- Investors should consider rebalancing their portfolios away from trying to maximize return in favor of maximizing consistency of the return.
- I would also strongly favor strategies that aim to directly manage the volatility of a portfolio rather than the return.
- While such strategies may result in lower projected returns, investors who employ them are more likely to achieve those returns because lower volatility goes hand in hand with staying invested.
February 16 is Do a Grouch a Favor Day. Therefore, as the resident grouch at Columbia Threadneedle Investments, I would like you to do me a favor. Since 2009, I have been grumbling and complaining that economic growth will be structurally lower than many investors expect. I called this outlook for economic growth the “square root” economy in which, after initially bouncing back from the great recession, we faced a prolonged period of low economic growth averaging approximately 2%.
Low growth in the "square root" economy
I believe we are still in this low growth area because of trends in demographics, private sector deleveraging, education and corporate investment policies. Economic growth is a function of the growth in the number of workers, the growth in their productivity and the amount of leverage. Most are fully aware of the aging trends in the U.S., Europe and Japan, but trends in other parts of Asia including China and South Korea are also poor for growth. If the number of workers in the developed areas is growing slowly or declining, then we are even more reliant on productivity growth and increasing leverage. Immigration helps, but remains politically charged. Productivity growth requires increased investment in education and training and investment in plant equipment and infrastructure. This is not happening at a sufficient rate. With demographic trends hampering growth rates, we need more investment than we experienced when those trends were favorable, not just the same amount. I don't see us returning to the careless lending and borrowing practices of the pre-2008 decade anytime soon. Therefore, increased private sector leverage is unlikely.
Growth does not occur evenly
Of course, growth does not occur evenly as suggested by the first chart. There will be periods of higher and lower growth as suggested by the blue line on the following chart.
This is normal: the world economy is too complex to grow steadily, and there are too many variables. However, our emotional behavior toward these variations, while predictable, is hard to control. We become too optimistic when growth is higher than the yellow trend line and too pessimistic when growth disappoints. That is reflected, indeed exacerbated, in the optimism and pessimism about financial markets. Actual GDP growth has followed a pattern similar to the path predicted by the “square root” theory. The chart below illustrates the projection and the reality.
GDP trends follow a similar path predicted by the "square root" theory
Clearly, a key issue in the financial markets is the pattern of over-optimism and pessimism we experience as a result of the low-growth economy.
While there are many economic and geopolitical issues to be concerned about, there are encouraging signs on employment, housing and car sales, to name a few. Therefore, the market correction which I described in a recent commentary as “good” because it relieved the pressure caused by overly optimistic predictions has created a reasonable valuation base supported by strong earnings. Note that I am referring to the level of earnings rather than the growth of earnings. Growth in net income will be muted because economic growth will be modest. Earnings per share may increase more because of share buybacks, but investors will increasingly need to question if the buyback is at the expense of investing in projects/people that could help future growth.
I believe that fair value for the S&P 500 is in the range of 1800 to 1850. That does not mean that pessimism won't drive it lower. If it does, there will probably be a buying opportunity. Because of low growth, there is only modest upside. Yet the swings from optimism to pessimism mean we are likely to experience volatility. Our global asset allocation team expects equities to have a relatively modest but reasonable relative return versus other financial market asset classes over the next five years. I support this expectation, but believe very strongly that most investors will not enjoy that return. The cycle of optimism and pessimism tends to lead investors to sell low and buy high, with actual returns failing to match the market average.
Aim for consistency of return
So do the grouch a favor and consider rebalancing your portfolios away from trying to maximize return in favor of maximizing consistency of the return. That probably means less equity exposure either in dollars invested or beta-adjusted. A dividend income fund may have a beta of 0.85 (implying 85 cents of exposure to equity volatility for every dollar invested) versus high-growth funds which may have a beta of 1.1 or higher. I would also strongly favor strategies that aim to directly manage the volatility of a portfolio rather than the return. While such strategies may result in lower projected returns, investors who employ them are more likely to achieve those returns because lower volatility goes hand in hand with staying invested.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.