FEATURE: MEAN VARIANCE
would have worked in practice. Th e strong negative
STATS.
correlation (-73%) between current adjusted PE
and subsequent 10-year returns suggests that there
is some merit in this approach. High ratios are FIGURE 1: EQUITIES AS % OF FINANCIAL ASSETS
associated with poor returns over the following
decade and low ratios typically portend a 10-year
Private pension funds
State and local government employee retirement funds
period of good returns. Importantly, at the end of
80
1998 this ratio was close to its all-time high
sets
70
suggesting that, based on this methodology, return
60
expectations for the following 10 years would have
50
been low.
o
t
al financial as
Of course, making asset allocation decisions is
40
more complicated in practice than simply looking
30
at cyclically adjusted PE ratios relative to the 20
long-term average. Moreover, it is easy to apply
Equities as % of t 10
these techniques with the benefi t of hindsight. Yet 08
0
this approach demonstrates the value in applying
52 57 62 67 72 77 82 87 92 97 02 07
even simple models.
Source: Federal Reserve, Russell calculations
RECENT EXPERIENCE
FIGURE 2: ADJUSTED PRICE EARNINGS RATIOS
A criticism of this approach is that the unusual
market turmoil of the past two years distorts the
Actual PE RoE adjusted PE PE 10
analysis. If equity markets had not fallen by so much 50
in such a short space of time, returns over the past
decade would have looked much more favourable.
40
So was it possible to have anticipated this diffi cult
period before the event? If so, then this detracts
30
atios
further from notions of market effi ciency.
PE r
In general, the short run is harder to forecast
20
since it is more diffi cult to diff erentiate noise from
genuinely valuable information. Nevertheless, some
10
high-profi le investors and market commentators
08
such as John Paulson and Nouriel Roubini predicted
0
52 57 62 67 72 77 82 87 92 97 02 07
the credit crunch.
Th ey may have got lucky or they may have
Source: Federal Reserve, Robert Shiller, Russell calculations
analysed the available information better than other
market participants. Here, we present analysis
FIGURE 3: THE CYCLICALLY ADJUSTED PE RATIO AS AN ALLOCATION GUIDE
indicating that no special skills were needed to have
shared the same investment view as Roubini,
Current cyclically adjusted overvaluation (LHS)
10 year return on equities over following 10 years (RHS)
Paulson and others. It highlights once again the 200 600
value of simplistic but insightful analysis. First, we
note the long standing relationship between the
500
aluation (%)
150
slope of the yield curve and growth. Figure 4 shows
400
how a negatively sloped US yield curve has correctly
100
eturn (%)
anticipated every recession since the 1960s. v
er / under v 300
Th e negative slope of the curve between August
50
t
ed o
200
2006 and April 2007 would therefore have given
ear equity r
an accurate signal of impending economic malaise,
y adjus
0 10 y
100
all
as it had done on the previous six occasions. An
clic
-50
investor might reasonably have believed this to
Cy
0
indicate only increased probability of recession
08
-100
rather than absolute certainty of one. Even so, this
52 57 62 67 72 77 82 87 92 97 02 07
-100
simple signal would have been suffi cient to
Source: Federal Reserve, Russell calculations
WWW.CFAUK.ORG PROFESSIONAL INVESTOR 25
23-2723-27 mean variance.indd 25mean variance.indd 25 1/6/091/6/09 11:50:4411:50:44Professional Investor Summer 09.27 27 4/6/09 15:40:55
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