We analyze markets through multiple lenses within our investment process. We believe a combination of business cycle analysis (macroeconomics), valuation analysis (prices paid) and technical analysis (charts and patterns) gives us the most complete picture of asset allocation and portfolio construction positioning at any given time.
The business cycle and market technicals tend to be more important to our shorter horizon market views by helping us express tactical portfolio shifts that have the potential to add value to portfolio returns.
The primary advantage of incorporating business cycle and technical analyses into our process is that they help us identify certain conditions that may perpetuate lower valuations in bad times and higher valuations in good times.
In other words, they help with timing — an attempt not to be too early when buying or selling. However, it is valuation that most often seals an investor’s long-term fate.
Author of the international best-seller The Alchemist, Brazilian novelist Paulo Coelho once said, “I can control my destiny, but not my fate. Destiny means there are opportunities to turn right or left, but fate is a one-way street. I believe we all have the choice as to whether we fulfil our destiny, but our fate is sealed.” Perhaps in the case of the current market environment, our fate is lower long-term returns as a consequence of currently stretched valuations. However unpleasant, we believe investors may find it difficult to escape the reality that paying a high price for a stream of future cash flows mathematically necessitates a lower expected return on investment. Shorter term, we believe an increase in volatility is likely, but we have not yet reached the end of the current business cycle.
Our work indicates a recession is unlikely in the near term; therefore, valuation multiples could remain high within the low inflation, low interest rate, slow (but steady) growth paradigm in which we live.
In this report, we choose to focus on the long term since ultimately that is the key focus for most of our clients. The 60% stock and 40% bond portfolio (60/40 portfolio) that is often thought of as the starting point for basic asset allocation decisions may no longer be sufficient to generate the returns required by many institutions and individuals to meet their long-term financial goals and objectives. Although financial assets may be unable to escape the fate dictated by today’s high prices, investors should consider taking certain actions to influence their portfolios’ ultimate destiny, as Coelho’s quote suggests. What can, or should, be done to alleviate pressure on portfolios that may fall short of their historical return targets? What are the consequences of those actions?
Here, we explore the details behind our own long-term return assumptions and risk management process while also focusing on ways in which investors can think about the relationships among risk, return, and portfolio construction in this lower-return environment.