GAM’s Howard: Cracking the asset allocation code amid ‘flashing red’ valuations

The CAPE ratio for US stocks is ‘well above’ its long-term average

Julian Howard, GAM
Julian Howard


By Julian Howard, investment director, multi-asset solutions at GAM Investments

In investments, often-competing philosophies and mantras abound. Despite the abundance of academic literature and professional qualifications, few have ‘cracked the code’ and delivered consistent outperformance. Investors are left to sift through centuries of past data to make their investing rules in the absence of a universally accepted rule.

Almost inevitably, different approaches result in contradictions. Even Warren Buffett has noted, trying to time markets makes fortune tellers look good, whilst also advising to “be greedy when others are fearful” – which is itself advice on market timing. As F. Scott Fitzgerald remarked, the test of a first-rate intelligence is the ability to hold two opposing ideas simultaneously.

Investors today also face a collision of investment ideas, specifically the very long-term case for equities versus overvaluation today.

See also: Five global equity funds boasting the highest yields and leading returns

The weight of evidence shows that long-term investing is the best way to generate superior returns. However, most investors can’t help but keep a nervous eye on the short-to-medium term. Indeed, many have liabilities they may need to meet over these periods.

And the ‘now’ is offering very little comfort. Over virtually every established metric, US stocks (accounting for 66% of the MSCI AC World Index) look expensive. The Shiller Cyclically Adjusted Price-Earnings (CAPE) ratio for example trades at over 30x, well above its long-term average.

Relative valuation measures are also flashing red. The state of the equity earnings yield versus the risk-free yield from cash is especially concerning. Today, short term US Treasury bills closely tied to the prevailing Fed Funds interest rate are giving investors a better yield than equities.

This effectively means that over the short term at least, there is just no case for stocks.

But with F. Scott Fitzgerald in mind, it is not intellectually inconsistent to keep holding equities. A good example of these historic periods of overvaluation would be the technology boom of 2001 or the housing expansion in the run-up to the global financial crisis of 2008.

See also: Are US equities overvalued, or are valuations just high?

Furthermore, just because valuations and relative equity premiums over risk-free rates are uninspiring now, they could yet improve. For example, the Federal Reserve could start lowering interest rates in 2024 given that headline US inflation has now eased to 3.2% at the latest reading. Alternatively, US corporate earnings prospects could improve given the unexpected resilience of US consumers and therefore the broader economy. Robust house prices and retail sales growth of (also) 3.2% make a good case for this.

For many investors though, even these reassurances are not enough and are looking for some way of transcending short-term overvaluation and the volatility that tends to come with it. In the multi-asset context, the obvious lever is asset allocation itself. But if the aforementioned poor fundamentals have already steered the equity allocation down to a more ‘neutral’ level in anticipation of worse future returns, the issue becomes whether an outright underweight is now appropriate.

Given the structural long-term case for equities, an underweight to the market carries significant risks around when to eventually re-engage. Recession and falling markets offer the best opportunity for this but also feel the most counter-intuitive.

However, it is both possible and entirely legitimate to build a more intrinsically resilient equity portfolio without having to resort to risky asset allocation decisions which could compromise the benefits of staying permanently invested.

See also: Soft landing or soft economy – what do rising bond yields signal?

One of the most inherently appealing ways to do this is via so-called quality stocks, in our view. While precise definitions can vary according to provider, quality stocks usually exhibit a solid and consistent revenue stream and are typically firms with strong margins and low levels of debt.

High quality firms therefore tend to have a high return on equity, a growing earnings profile and low leverage on their balance sheets. Intuitively, and in practice, such characteristics are desirable during periods of volatility and/or overvaluation.

Quality stocks also offer style diversification. Emphasising growth stocks with their exposure to tech themes like artificial intelligence (AI) is a sound way to transcend a world of economic stagnation but it has its ups and downs. A complementary, sector-neutral quality allocation can help smooth this out over time. In this sense, we believe quality is also a better diversifier than value (essentially cheap stocks) because it tends to avoid fundamentally challenged business models in the first place.

Markets today are presenting an uncomfortable challenge to all but the most committed. It is no exaggeration to declare that fundamentals are sub-optimal right now but that the intrinsic case for stocks over time remains undimmed. Investors need to reconcile this stark contradiction without taking drastic and potentially risky action like outright underweighting equities and thus being ‘out of the market’ with all that entails.

While no investment portfolio holding even a modest exposure to stocks is going to be free of volatility, careful style selection can optimise risk-reward within said exposure and make the short term that much easier to digest.

Latest Stories