As we have discussed before, poor stock selection, primarily from March 2010 through March 2011, caused by a particular group of stocks has hurt our performance. We have made some direct adjustments to our stock selection to handle the immediate issue and are researching more general long term adjustments to prevent similar situations in the future.
However, it still has put us in a position were we have lagged the market by more and are off our peak by more than we would expect at this point in the stock market cycle. This can make the normal volatility going forward feel more significant than it otherwise would feel. However, the approach does have the ability to work its way out of this situation.
The Way Forward
Typically, the approach will be able to participate with the market as it advances when our measures of the trend are positive. That in itself should allow us to move forward in terms of absolute returns and reducing the amount we are below our peak level.
Alternatively, if our measures of trend turn negative this typically opens up a window where the market could do very poorly. Periods where the market performs poorly can create opportunities to invest when the market is trading at a low price relative to its value (which we estimate with our Long Term Reversal Factors). Longer term this can help in terms of both relative and absolute performance.
Current Environment
If the S&P 500 were to be trading at what we consider fair value 7 years from now it would be slightly lower than current levels. So we don't believe there is much long term return purely from a buy and hold strategy at these levels.
However, there still remains a wide range of possible outcomes. As an example, let's first assume the S&P 500's fair value increased 6% per year, in line with its historic performance, from its peak in 2007 using monthly data. In order to be at the same value today as at the peak in 2007 the S&P 500 would have to be at 1899.89 (compared to 1363.61 currently). Using those same assumptions, to be at the same value as its low in 2009 the S&P 500 would have to be at 834.01. To be at those extremes would require either an immediate 39% increase from current levels or an immediate 39% decrease.
Looking out further the potential upside grows, even if those gains are ultimately all erased during the next bear market. The chart below helps give some idea of the range of outcomes if we just stay within the valuation range (assuming constant 6% annualized growth) of the prior bear market.
Of course, the prior bear market doesn't encapsulate the full range of outcomes, such as including the peak in 2000 or the low of 1932. The real range and path over the next seven years is going to be based on things such as the frequency and severity of recessions and the interest rate environment, which are usually associated with changes in risk tolerance. By observing indicators that inform whether risk tolerance is changing as it is changing we believe we are better able to handle the potential wide array of outcomes than being tied to a specific forecast of when they might change.
To the extent our ability to adjust is in line with historic averages, and the market returns to what we consider fair value in 7 years, we should be able to provide a return that is both higher than the market and with less overall risk. To the extent the market does better over those 7 years our absolute return may benefit, but our relative performance may not be as strong. However, it will give the market greater potential for weaker performance in the following 7 years, in which case our relative performance should recover. To the extent the market does worse our relative performance should benefit and absolute performance may suffer, but it will give the market the potential to do even better than average in the following 7 years and our absolute performance should improve as well.
Ideal Stock Market Exposure Increased
Our Intermediate Term Trend Factors have turned positive. Our Long Term Reversal Factors remain negative. Our Ideal Stock Market Exposure has been increased to 70-80%.
