An Investing Strategy For Our Current Bull Market

posted in: Other | 0, Summer, 2017. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

In times of high prices, investors often turn to so-called relative value investing to gain a sense of where they should be allocating their capital. For instance, if U.S. stocks are expensive compared to, say, European stocks, a relative value investor would sell U.S. stocks and buy European stocks.

Relative value investing draws its theoretical underpinnings from the “law of one price,” which dictates that the same security should have the same price in all forms and in all markets. Therefore in relative value investing, if two securities have similar properties and different prices, then you should buy the cheaper of the two.

So far, so good.

In an effort to capitalize on the value of this principle, at my firm, we follow approximately 80 markets around the world and ask questions about how they compare to each other on a relative valuation basis, relative to their own history and on an absolute basis. Currently, we think emerging markets look relatively cheap compared to U.S. markets. We also believe that high yield bonds look relatively expensive compared to investment grade bonds. And stocks in India look expensive relative to stocks in Brazil.

However, if we focused on the relative value of assets to the exclusion of all other inputs, and made the above trades, the results would likely be sub-optimal.

That’s because when observing relative prices at a moment in time, you might miss the obvious: Most of the world looks expensive today. So while high yield debt might look rich relative to U.S. investment grade debt, both asset categories are expensive relative to their long-term valuation.

The danger posed by a relative value model in isolation can be seen in the simple observation made by Robert Shiller, which was the theoretical underpinning of his Nobel Prize in economics. Specifically, when prices are high in historic terms, future returns over the next 3-5 years tend to be low, and when prices are low in historic terms, returns tend to be high over the next 3-5 years.

Thus, identifying that you might be slightly better off holding investment grade bonds versus high yield bonds fails to acknowledge the historically high prices for both assets classes and the expected lower future returns for both.

It’s important to understand when almost everything is expensive, the market is implying very different and contradictory things about the future. For instance, look at stocks and bonds. When bonds are expensive, the market is implying slower future growth. When stocks are expensive, it tends to imply higher future earnings and growth. Going back to the law of one price we know one of those conclusions is wrong.

The takeaway is that when all assets look expensive, the best defense is a diversified portfolio. Relative value investing may limit the hit that your portfolio might take, but it is a poor substitute for the protection a diversified portfolio offers. This is exactly why it is often said that diversification is the only free lunch in investing, because as the above scenario incorporating high priced stocks and high priced bonds demonstrates, when one of them falls — and one of them will — the other will likely rise. That’s when diversification does its best work. Will you join me for lunch?

Click here to see the article on Forbes.