Monday, April 30, 2007

Random Walker

Burton Malkiel, the author of A Random Walk Down Wall Street has a very interesting editorial in the WSJ today. The article is primarily about the reduction of risk premiums in financial assets:

The facts are that stock prices are high not only in the U.S. but also in the world's developed and emerging markets. We can estimate long-run annual equity returns by adding today's dividend yield (just under 2%) to the likely future growth rate of earnings and dividends (perhaps 5.5%). This calculation suggests that stocks are priced to produce about 7.5% future returns, well below the 10.5% annual returns achieved from 1926 through 2006. Treasury bond yields (at just under 4.75%) are historically low, as is core inflation, running close to 2%. The prospective equity risk premium (the amount by which stock returns are likely to exceed bond returns) of about two and three-quarter percentage points appears to be well below the five percentage point equity risk premium earned since 1926. We are not being paid as much to take on the risk of holding stocks.

Not only are equity premiums low; so are bond risk premiums. The spread between high-yield bonds (more pejoratively called junk bonds) and safe U.S. Treasuries is just about at an all-time low. Sovereign emerging-market debt yields are not much more than two percentage points over U.S. government debt. The VIX index, measuring expected U.S. stock market volatility, is extraordinarily low. These measures imply that financial markets are very relaxed about risk and that the world is a very stable place.

This is something I've touched on before and I agree with Mr. Malkiel. He goes on to say that there may be reasons why the markets are not pricing in as much risk as in the past. The reduced volatility of economies in general and the subsequent reduction in the volatility of earnings may mean that stocks and other financial assets are priced correctly. And as an efficient market believer (one place we part company) he is reluctant to believe that markets are mispriced. However, he also states:

I believe that markets are high and risk spreads compressed because of massive increases in world liquidity. A world awash in dollar-based purchasing power has helped to keep our interest rates low and the spreads on risk assets tight.

This, to me, seems inconsistent with his stated belief in efficient markets. If the world is "awash" in liquidity, doesn't that imply that there is something wrong in the system? Doesn't it imply that the central bankers of the world are doing something wrong? And doesn't that imply that assets are mispriced because of the distortions caused by the central bankers?

Mr. Malkiel ultimately gives some good advice though:

So what should investors do as the Dow rises to new highs? Should they "sell in May and go away," as one stock-market bromide suggests? As a student of markets for over 50 years, I am convinced that attempting to time the market is a fool's game. But new highs in the market should induce investors to review their asset allocations. If the rising stock market has pushed your allocation of equities well above the level consistent with your risk tolerances, it makes sense to consider rebalancing. Rebalancing is an excellent strategy to constrain your investment risk in a very uncertain world.

We are always evaluating exposure to the various markets we cover so rebalancing in our tactical portfolios is something that happens regularly, but our investment models are all based on static portfolios with regular rebalancing, generally 2 years. Rebalancing generally forces investors to sell some of what has gone up and buy some of what has not. Sell high, buy low. Good advice.

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