• Asset Allocation: Expensive Equities & Risky Bonds
  • An Imperfect Solution in a Land of Low to Negative Yields
  • Conclusion: The Benefits of Balance

Asset Allocation: Expensive Equities & Risky Bonds

Having noted that Warren Buffett’s favorite aggregate valuation metric was above levels seen at the peak of the dot.com bubble, we penned Why Market Neutral Now in January 2020. That paper documents the benefits of owning investment products agnostic of market direction that strive to preserve and compound wealth slowly, particularly during periods of elevated market valuations. Despite insisting that we lacked any ability to time markets, when merely weeks later equities experienced their sharpest and most violent decline since the great depression, Kailash would be lying if we did not admit to feeling intelligent. That feeling proved ephemeral as the crash lasted only 23 trading days, and US markets have since recovered nearly all losses.

The statement, “US markets have recovered nearly all of their losses,” underpins the purpose of this paper. Once again, Kailash attests to the obvious – we have no capacity to time markets but they are once again expensive relative to history. While a poor timing tool, the brief but violent sell-off that followed February 19th wiped out all market returns since 2017, as documented in our paper Crashes: When Losers Become Leaders. Kailash’s piece Value Investing & Manias documented that growth and value spreads have blown out to levels not seen since 2000. We believe this near-record dispersion in equity valuations offers allocators a solution to the increasingly difficult problem of sourcing non-correlated returns from nearly-zero yielding bonds.

Figure 1 shows the compound return on a dollar getting long the cheapest decile of firms based on price to sales while being short the most expensive decile. With 0 net exposure, an investor following this naïve approach would build wealth over time. Kailash believes the period into the peak of the internet mania, GFC, and the period following the start of 2017 are informative, as indicated by the bubbles within Fig. 1. In the prior periods, value stocks have been ruthlessly punished by their growth peers resulting in meaningful losses for someone invested in such a naïve strategy. Subsequent to such periods, however, the benefits of sticking out the pain resulted in immense returns as value stocks went on to trounce their growth peers.


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