Risk & Reward Distortions in an Uncertain World

Transcription

1 CIO REPORTS The Monthly Letter Office of the CIO OCTOBER 213 Risk & Reward Distortions in an Uncertain World Investors are often caught between two very different needs to maintain the safety of their assets and to achieve a healthy rate of return. The dilemma these needs pose is particularly problematic today, since market valuations have strayed further than normal from equilibrium. The traditional relationship between risk and reward is distorted. This distortion in the post-28 world has been driven by two factors: Central banks around the world have coordinated their policies and artificially lowered interest rates worldwide. Combined with large fiscal deficits, their actions have increased the total money supply and made borrowing cheap. The objective is to inject liquidity into the economy in the hope of stimulating growth. Fearing another cataclysmic market sell-off, investors have displayed a high degree of risk aversion. They have tended to avoid equities, preferring to hold larger than usual allocations of cash and bonds. The confluence of these two factors has distorted the relative values of the two dominant asset classes: equities and bonds. EQUITIES Consider a traditional measure for evaluating opportunities in the equity market: the price/ earnings ratio, or P/E ratio. Today, the P/E ratio based on past one-year earnings of the companies comprising the S&P 5 Index stands at about 2 1. A rough way of understanding this ratio is that you can expect an annual return of 1/2th of capital you invest in the market, or an annual return of 5% on your money. The current P/E ratio is higher than its long-term historical average of 16. This disparity implies that future returns over a complete market cycle may be mediocre, unless growth kicks in. After all, a 5% rate of return on equity doesn t seem particularly exciting. Ashvin B. Chhabra Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance We are in an uncertain world where bonds are expensive and it is increasingly challenging to find value in equities. However, investors should not believe they need to choose between relative safety and an uncertain path. Instead, they need to strike the right balance between them. A balanced approach through the allocation of risk will go a long way in navigating this uncertain world. Sincerely, Of course, any single measure of the stock market has its shortcomings. This P/E measure tends to fluctuate widely, as short-term earnings can be quite volatile. For example, in January 29 the P/E ratio of 7 2 implied that stocks were very expensive, even after prices had fallen substantially. This was because the economy was on the brink of a meltdown and, for most companies, earnings were non-existent or extremely low. If the economy had not 1 Based on trailing 12-month reported S&P 5 earnings from Robert Shiller as of October P/E based on trailing reported 12-month earnings from Robert Shiller. This P/E ratio reached 12 in May 29. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation. Investment products offered through MLPF&S: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value 213 Bank of America Corporation. All rights reserved. Please see important disclosure information on the last page.

2 recovered, the perception that stocks were expensive would have proven true. Since then, however, there has been a strong normalization of earnings from the lows of early 29, and the opposite has proven to be the case. Also notice how quickly the ratio readjusted to expectations of recovery. This experience provides a clear illustration of the difficulty of waiting for the economy to show definite signs of progress before investing. Exhibit 1: 12 Month Trailing Price to Earnings (P/E) Ratio Month Trailing P/E Ratio Average Month Trailing P/E Ratio Historical Average (see above) Data for 213 is through October. One way of overcoming the volatility of short-term earnings is to look at historical earnings over longer periods of time. The Shiller P/E ratio (devised by none other than one of this year s Nobel Prize winners, Robert Shiller) uses the average of the last 1 years of (inflation-adjusted) earnings to produce a P/E number adjusted for market cycles. Exhibit 2: Price to Cyclically Adjusted Earnings Ratio (Shiller P/E) Shiller Cyclically Adjusted P/E Ratio Average Data as of October 213. The Shiller P/E today stands at 25, well above its historical average, signaling that stocks are expensive. This is a cautionary indication that the current price of stocks already reflects expectations for comparatively strong earnings, compared with the last 1 years, leaving limited upside. BONDS Now let s look at bonds. The current yield on the 1-year U.S. Treasury bond is 2.5% 3. Exhibit 3: 1-Year Treasury Yield Year U.S. Treasury Yield Average Data as of October 213. The equivalent P/E 4 would be 1/.25, or 4. This is quite far above the historical average of 26. When people talk of a bond bubble, or say that bonds are very expensive, this is what they mean! Exhibit 4: Bond Yields and Price to Earnings (P/E) Ratio Year U.S. Treasury Yield Average 1 Year Bond Yield 1 Year U.S. Treasury P/E (Right) Average 1 Year Bond P/E (Right) Data as of October 213. Simply put, in an uncertain, higher-risk world, neither investment choice (bonds or equities) looks great. Treasury bonds may offer an element of protection, but the cost is high. Equities may give you upside potential but one must be able to withstand the Bond P/E Ratio 3 Using current 1-year Treasury Yield from Bloomberg as of October 3, Bond P/E calculated as the inverse of the 1-year bond yield. CIO REPORTS The Monthly Letter 2

3 prospect of a strong market sell-off. However, this analysis does indicate that there is a relative reward for taking on a moderate amount of risk. This is the reward an investor gains if he or she avoids being too fearful and does not demand (or pay for) protection on all of his or her assets! THE FEDERAL RESERVE In addition to fearing a market sell-off, investors fear inflation. However, the Federal Reserve (Fed) is carefully watching for signs of an economic slowdown. Exhibit 5: Consumer Price Index Year-over-Year Change Consumer Price Index YoY Change Average The Fed views a moderate amount of inflation as a healthy sign of a recovering economy. Notice that, while inflation at present is low, the entire era since 1955 (with the exception of 29) has produced consistently positive inflation. For investors, any long-term investing strategy must strive for returns that at least meet or exceed inflation. Such an investment strategy favors equities over bonds. The Fed is also watching the unemployment rate as a key indicator. Chairman Ben Bernanke, a scholar of the Great Depression, has made no secret of his determination to avoid a repeat of the devastation caused by large-scale unemployment during that period. The recent government shutdown and sequestration will lower gross domestic product (GDP) growth, which would in turn imply the continuation of the Fed s policy of keeping interest rates artificially low. Ethan Harris, BofA Merrill Lynch Global Research Chief U.S. Economist, recently lowered his forecasts for Q1 214 GDP growth from 3.3% to 2.8%. Exhibit 6A: U.S. Unemployment Rate U.S. Unemployment Rate Source: Bloomberg and ML GWM Investment Management & Guidance. Exhibit 6B: U.S. Unemployment Rate During the Great Depression U.S. Unemployment Rate ( ) Source: Robert Coen and ML GWM Investment Management & Guidance. WHAT SHOULD INVESTORS DO? It is important to remember that U.S. Treasuries continue to provide a diversification benefit to an equity-oriented portfolio. Exhibit 7: U.S. Treasuries Still Provide Diversification to U.S. Equities Correlation between annual total returns of U.S. Equities and U.S. Treasuries (rolling over 5 years) Source: Robert Shiller, ML GWM Investment Management & Guidance. Data as of September 213. As a first step toward resolving the challenge of maintaining the safety of assets while achieving a healthy rate of return, investors should consider the concept of Risk Allocation. CIO REPORTS The Monthly Letter 3

4 One way of accomplishing Risk Allocation is to mentally or explicitly segregate assets into two distinct portfolios, each with a clear and distinct goal: a safety portfolio and a market portfolio. Exhibit 8: Allocating Between Safety and Market Assets Market Assets Safety Assets Investment Portfolio Source: ML GWM Investment Management & Guidance. For illustrative purposes only. As its name implies, a safety portfolio has a clearly defined goal to preserve capital, even at the cost of trailing the market return each year. With interest rates having reached their recent lows, the opportunity cost of holding such a portfolio is high. The cost is evident in the comparison of the P/E ratios of bonds and stocks. As you structure this portfolio with assets such as short-term U.S. Treasuries, a bond ladder, cash and other protective holdings, you must remain focused on its purpose short-term safety and liquidity. Investors must realize that the search for yield enhancement in this portfolio will often come with increased risk, contrary to the objective of the portfolio. As a result, deviating from that objective may result in it failing to meet its objective precisely when you need it the most. The complementary portfolio is the market portfolio. Its goal is to earn, over a full market cycle, the market return by harvesting both equity and credit risk premiums. This outcome is best achieved by making sure your holdings are truly diversified and that you have both the financial stability and the mental fortitude (investment discipline) to hold on to them through any steep market sell-offs. While return expectations may be muted compared to a few years ago, the attractiveness of the market portfolio compared to the safety portfolio remains strong. A key decision for each investor will be how to divide assets between these two portfolios a decision that should be made today rather than amidst a market crash. Of course, one must revisit the allocation decision periodically, in order to rebalance and reassess. Risk Allocation is one of the most important decisions an investor can make in order to ensure the attainment of essential goals while also trying to achieve a reasonable rate of return from the total portfolio. The key lesson here is that the decision before investors is not the choice between relative safety and an uncertain path, but rather of finding the right balance. Risk and return may indeed be distorted in the world today, but clear thinking about priorities and goals and the adoption of a balanced approach through Risk Allocation will go a long way in navigating this uncertain world. CIO REPORTS The Monthly Letter 4

5 When considering your portfolio in light of our current guidance, consider the tactical positioning around asset allocation suggested below in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate given your specific circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility and suitability criteria. Your Financial Advisor can help you to customize your portfolio in light of your specific circumstances. ASSET CLASS BENCHMARK STRATEGIC ASSET ALLOCATION FROM RIC* TACTICAL POSITIONING RELATIVE TO STRATEGIC ASSET ALLOCATION Cash 2% UNDERWEIGHT Global Equities 45% U.S. Large Cap U.S. Mid & Small Cap International Developed 21% 18% Emerging Markets 6% Global Fixed Income 33% U.S. Treasuries U.S. Municipals U.S. Investment Grade U.S. High Yield & Collateralized Non-U.S. Corporates Non-U.S. Sovereigns Emerging Market Debt Alternatives** Commodities/ Currencies N/A Included in Real Assets UNDERWEIGHT Hedged Strategies 9% Real Assets 4% TIPS attractive after Q2 sell-off. Private Equity 7% *Moderate Global Allocation Tier 2 Liquidity. **Alternative Investments are available only to pre-qualified clients. Source: Merrill Lynch Investment Management & Guidance, October 213. OPPORTUNITIES AND RISKS Current returns are negative on a real basis in developed markets; we want to get paid to wait, and the perceived safety of cash may be overstated in an age of financial repression. In developed markets, valuations are fair and they are becoming attractive in Emerging Markets. Corporate fundamentals are excellent. Income generation remains a major theme within portfolios and dividend growth continues to play a major role. Consider sector rotation toward cyclicals as the U.S. economy improves; these sectors still offer attractive dividend opportunities. Reduce utilities and telecom. Financials remain an opportunity. Small caps are likely to continue benefiting from ongoing domestic recovery. Valuation dispersion in small caps remain high and an opportunity for active management. Positive M&A outlook is constructive for small caps. BoJ committed to continue quant easing and valuations are fair. The yen remains the key consideration; Eurozone in recession but stabilizing; valuations remain favorable and liquidity actions of the ECB are supportive. See opportunities through 2H 213 but volatility likely to remain. The bias remains for euro weakness, therefore, hedge euro equity exposure. The prospect of slower growth combined with the withdrawal of Fed liquidity reduces previous optimism on the region. Short term, prefer countries with stable capital account positions, which may tactically outperform on the back of weak sentiment. Longer-term, look beyond index like exposure to focus on smaller emerging countries and frontier markets. In a rising rate environment, seek differentiation in returns across sub-segments. Duration management remains paramount in portfolio positioning. Prefer credit risk over duration risk. Negative real returns and Fed intervention have created highly overvalued and unattractive conditions. We see better risk/return elsewhere. Within Treasuries, prefer short and intermediate duration. Valuations relative to Treasuries remain attractive and tax-exempt status is not likely to be threatened anytime soon. Prefer essential service revenue bonds and high-quality, actively selected credits. Consider positioning toward short to intermediate duration and state over city GO (general obligation) bonds. Some opportunities remain here, but in the final stage of the investment grade rally. U.S. bank bonds may have more room to rally. Very sensitive to a rise in rates, positioning should focus on shorter duration. Corporate fundamentals remain supportive of investors taking credit risk and default rates will likely remain low. Valuations will overshoot this cycle on quality of balance sheets. HY plays a role in diversifying sources of income, as the search for yield continues. Look to new credit opportunities such as senior loans. We continue to want to be cautious on Eurozone debt, despite the improving liquidity environment as we expect rate volatility to remain above average and indices have high weight to European banks, which still need to re-capitalize. We like opportunities in this space but advise active manager exposure. Country specific domestic policy to dominate rates and currency performance. More value in higher quality EM credits that too have sold-off, however, Fed liquidity withdrawal introduces uncertainty for the aggregate market. Short term, avoid current account countries susceptible to investor outflows and a stronger U.S. dollar. Stress the need for management of currency exposure. Active managers can better exploit the opportunity set. Oil provides a hedge against political instability and select agriculturals looking short term oversold. Industrial metals remain dependent on growth in China. In a total portfolio, prefer low vol and non-directional strategies such as global macro to provide diversification from our preferred equity overweight. Within more directional strategies prefer equity long/short and relative value. High conviction in private equity as the combination of an improving economy yet banks still reluctant to lend provides attractive opportunities. CIO REPORTS The Monthly Letter 5

6 OFFICE OF THE CIO Ashvin B. Chhabra Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance Mary Ann Bartels CIO, Portfolio Solutions, U.S. Wealth Management Christopher J. Wolfe CIO, Portfolio Solutions, PBIG & Institutional GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client s investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. Asset allocation and diversification do not assure a profit or protect against a loss during declining markets. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investment returns may fluctuate and are subject to market volatility, so that an investor s shares, when redeemed or sold, may be worth more or less than their original cost. Alternative Investments are speculative and subject to a high degree of risk. Although risk management policies and procedures can be effective in reducing or mitigating the effects of certain risks, no risk management policy can completely eliminate the possibility of sudden and severe losses, illiquidity and the occurrence of other material adverse effects. 213 Bank of America Corporation. All rights reserved. ARNV8MQY