You’ve probably noticed your portfolio soaring these past few months.
The Slow & Steady portfolio is up more than 5% since last quarter. That’s despite it being 40% bonds.
Property’s 10% quarterly rebound is especially heady. Mind you, I’d estimate my REIT fund is still down around 5% since the eve of the coronavirus crash.
As the world learns to live with Covid, confidence is shooting through equity markets like bubbles in champagne.
What could go wrong?
It’s at moments such as this – with the Slow & Steady’s returns just shy of 10% annualised – that I like to think about how it could all end in tears.
(I’m giving up FIRE, by the way, for a new gig as a professional party-pooper.)
There’s a drumbeat of concern about ‘overheating’ out there. And it’s always better to burst your own bubble than to have someone do it for you.
So let’s scare ourselves silly with some frothy (over-)valuation porn.
But first, let’s bask in this quarter’s lovely numbers. Just for a moment!
Returns brought to you by Don’t-Worry-Be-Happy-O-Vision:
The Slow & Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000. An extra £985 is invested every quarter into a diversified set of index funds, tilted towards equities. You can read the origin story and find all the previous passive portfolio posts tucked away in the Monevator vaults.
Valuations of doom
Okay, that’s enough basking. If our returns can’t deliver negativity then we’ll just have to do it ourselves.
Dialling up today’s market valuations and miserly expected returns is a quick way to pee on our fireworks.
One of the few equity valuation indicators thought to have some predictive power is the cyclically-adjusted P/E ratio (aka CAPE, aka P/E10, aka Shiller P/E…).
The Investor has written an excellent piece explaining how CAPE works. He also looked at its limitations and pitfalls.
To cut to the chase, there appears to be some correlation between a stock market’s CAPE measure and future stock returns. How much? You can find material arguing the case either way. But – especially in the US – there’s evidence that a historically high CAPE signals poor market returns ahead.
Right now the US CAPE measure looks lofty.
Brace! Brace! Brace!
CAPE ought to be relevant in other countries, too. But good data is hard to find.
Thankfully, help is at hand from fund manager Research Affiliates.
Donning the cape of data superheroes – look, I’m having fun even if you’re not – Research Affiliates has calculated CAPE ratios for every major world market.
That data is packaged up with Research Affiliates’ 10-year expected returns in a superb CAPE Ratio tool. Thus armed, we can look to see where pockets of opportunity and danger may lie.
++Caveat warning++ This only matters if you lend any credence to CAPE as a metric, you concur with Research Affiliates’ methodology, and you believe passive investors have any business reading such tea leaves. ++Caveat warning ends++
Credit to reader Stephen James for sharing Research Affiliates’s tool. (No sniggering at the back.)
UK stock market valuation
Here’s the CAPE ratio, expected returns, and fair value reading for UK equities according to Research Affiliates:
Squint at the UK’s candlestick (bottom-centre of pic) and you can see that our home CAPE is 13.5. That’s a touch lower than the historical median of 14.3. (Research Affiliates’ UK CAPE time series dates back to 1980).
The black ‘X’ on the red column shows a fair value estimate. It’s bang on the 14.3 median CAPE score, and so just above today’s actual valuation.
(Note: Research Affiliates’ fair value isn’t always the market’s historic CAPE median).
Looming larger than any of that is the 10-year average expected return of 4.9% for UK equities. That’s a real (after-inflation) annualised return.
The green cumulative probability bar (bottom-right) gives only a 50-50 chance of us hitting those heights. There’s a 75% chance of scoring at least 3.4%. There’s only a 25% chance of topping 6.4%.
Still, based on historic data you wouldn’t expect to squeeze more than 5% average return out of UK equities anyway.
The UK looks okay then. But the US does not…
US stock market valuation
After the heroics of the last 12 years, US large cap expected returns are predicted to deliver a median of -0.9%. That’s as bad as today’s negative-yielding bonds!
Research Affiliates believes there’s only a 5% chance of scraping a measly 2.7% annualised over the next decade.
Many Monevator readers will maintain a large allocation to the US. Not least in their global tracker fund.
The Slow & Steady’s allocation to the US is 26%.
(The portfolio is 39.6% allocated to the Vanguard FTSE Developed World ex-UK fund. That fund holds 67% in US equities. 39.6% x 67% = 26.5%.)
Research Affiliate’s median forecast would hurt us if it came to pass.
The US candlestick notches a CAPE of 37. (See the white circle shinnying up to the 98th percentile of the historic range.)
That’s way beyond the CAPE ratio of 30, hit on the eve of the 1929 Wall Street Crash according to this calculation:
The S&P 500’s peak CAPE was 44, just before the dotcom bubble burst.
Look out below
In the US we’re back into nose-bleed territory. Then again, we have been for a long time.
The Investor cited the same US CAPE source back in 2012. It showed CAPE at 23. That seems tepid now, but the US market was considered to be overvalued even then.
Many knowledgeable-sounding commentators warned that US equities were frothy and there was trouble ahead. They’ve been wrong (or just early) for nine years.
I have often doubted the wisdom of sticking to my passive guns when I’ve read about US valuations. But if I’d cut back I’d have missed the main driver of global equity returns for the past decade.
Still, a US CAPE of 38 is scary.
But if you want to see something truly gaga then check out Japan’s CAPE history.
Japan stock market valuation
It’s the historical range of Japan’s P/E10 that makes my eyes bulge.
Beyond the red column, Japan’s slender grey upper shadow extends to an all-time high north of 90.
I’ve read that the Japanese Nikkei index’s P/E ratio reached 70 just before its bubble burst in 1989.1
As super-heated as US valuations are now, Japan’s experience suggests they can keep gathering steam.
Passive investors aren’t meant to respond to market signals. We avoid action because we know we have no edge.
Despite this I’ve often wondered how I’d react in a market delirium.
If I’d been investing in Japan in the 1980s, would I have scaled back as its CAPE climbed through the 40s and beyond?
I previously told myself: yes. But how easy would that have been? The Japanese economic model was lionised at the time. Some predicted Japan would soon eclipse America.
Now the US CAPE is approaching 40.
I am fully prepared for a decade of low returns. Equities have had a barn-storming run, after all.
But I don’t believe I can use CAPE to predict a bubble and nor should you.
Some like it hot
There’s an internet full of arguments for and against CAPE.
Vanguard research has previously put CAPE’s correlation with future equity returns at around 43%. So there are clearly a lot of other factors in play.
I think that CAPE is a useful indicator. At the very least it helps you gauge what others mean when they mysteriously refer to ‘valuations’.
But so far I haven’t acted on CAPE’s fuzzy signal.
Even then Monevator’s mail bag was full of worries about markets overheating.
Like frogs in a pan, we just keep on boiling.
Every quarter we throw £985 into the global market furnace. Our financial fuel is split between seven funds, as per our predetermined asset allocation.
We rebalance using Larry Swedroe’s 5/25 rule. That hasn’t been activated this quarter.
These are our trades:
Vanguard FTSE UK All-Share Index Trust – OCF 0.06%
Fund identifier: GB00B3X7QG63
New purchase: £49.25
Buy 0.221 units @ £223.21
Target allocation: 5%
Developed world ex-UK equities
Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.14%
Fund identifier: GB00B59G4Q73
New purchase: £364.45
Buy 0.719 units @ £506.90
Target allocation: 37%
Global small cap equities
Vanguard Global Small-Cap Index Fund – OCF 0.29%
Fund identifier: IE00B3X1NT05
New purchase: £49.25
Buy 0.123 units @ £399.46
Target allocation: 5%
Emerging market equities
iShares Emerging Markets Equity Index Fund D – OCF 0.17%
Fund identifier: GB00B84DY642
New purchase: £78.80
Buy 38.875 units @ £2.03
Target allocation: 8%
iShares Global Property Securities Equity Index Fund D – OCF 0.17%
Fund identifier: GB00B5BFJG71
New purchase: £49.25
Buy 20.746 units @ £2.37
Target allocation: 5%
Vanguard UK Government Bond Index – OCF 0.12%
Fund identifier: IE00B1S75374
New purchase: £305.35
Buy 1.69 units @ £180.71
Target allocation: 31%
Royal London Short Duration Global Index-Linked Fund – OCF 0.27%
Fund identifier: GB00BD050F05
New purchase: £88.65
Buy 79.081 units @ £1.12
Target allocation: 9%
New investment = £985
Trading cost = £0
Platform fee = 0.35% per annum.
This model portfolio is notionally held with Fidelity. Take a look at our online broker table for cheaper platform options if you use a different mix of funds. Consider a flat-fee broker if your ISA portfolio is worth substantially more than £25,000. The Slow & Steady portfolio has long since passed that threshold. I’ll explore a move to a flat-fee platform in the next installment.
Average portfolio OCF = 0.15%
Interested in tracking your own portfolio or using the Slow & Steady investment tracking spreadsheet? This piece on portfolio tracking shows you how.
Take it steady,
I’ve also read that differing accounting standards explained some of Japan’s wild P/E ratio, though not all of it.
The post The Slow and Steady passive portfolio update: Q2 2021 appeared first on Monevator.