The Everything Bubble

As I've suggested in some previous posts, assets in developed countries are currently very expensive relative to historical norms by almost any measure. This includes stocks, government bonds, corporate bonds, high risk debt, and real estate.

We know from historical investment return data that it's better to buy things when they are cheap on both relative and absolute terms. For example, if you are looking at U.S. stocks, you would have been much better over long time periods buying the cheapest stocks (value investing) than expensive stocks (growth investing).

However, value stocks were also more volatile and had larger drawdowns. This is why there has been an advantage to value stocks. Larger drawdowns scare investors and drive down the value of those stocks (risk vs. reward). If you're disciplined, you can pick up the pieces and do well.

Bonds are no different. In the 32 years before 1985, an investor in 10 Year Treasuries would have achieved an inflation adjusted return of just 1.65% per year. From 1985 (when yields were in the double digits) to now, the annual inflation adjusted return was almost double at 3.09%. Again, it's better to buy cheap bonds than expensive bonds.

Real estate will be a very interesting tell in the coming decades as the value of real estate is correlated to the inverse yield of bonds (bond yields determine mortgage rates). In 1953, the average house in the U.S. cost $17,000 and $82,000 in 1985. This results in an inflation-adjusted return of approximately 0.5%. Makes sense because interest rates climbed substantially during this period.

However, from 1985 until today, house prices have climbed to $310,000 for an annualized return of 1.6% after inflation. More than double the pre-1985 thirty-two year return. But interest rates fell after 1985. These stats also demonstrate the pathetic returns offered by residential real estate even with an interest rate tailwind.

Future Return Expectations

History can be a great guide to the future. History might not repeat itself per se, but markets work in cycles and are remarkably similar over and over. We can use this knowledge to serve as a guide with some degree of accuracy.

Developed Country Stocks

Stocks are currently valued at some of the highest historical levels ever. By most measures (CAPE and Cap/GDP), it is at or near the market peaks of 2000 when stocks had two 40% crashes in the next 10 years taking values back by a decade.

John Hussman uses a unique market cap tracker measuring non-financial equities to GDP. This metric—which has remarkable accuracy going back to the 1920s—predicts a future twelve-year return of 0% as of last month.

Source: John Hussman - Hussman Funds

If you don't like Hussman, or his metrics, look at Shiller CAPE for U.S. stocks. Developed market stocks led by the U.S. are expensive and there is no denying that.

Shiller PE Ratio - Source: Multpl.com

However, there are deals out there based on fundamental evaluation. Emerging markets are pretty reasonable led by Russia and Brazil which are cheap. Australia, the U.K., and China are also quite reasonable relative to historic norms and comparable countries.

Bonds

Currently, bond yields are as low as they've ever been in modern history. In some countries they are less than the current rate of inflation. It's pretty reasonable to believe that in the coming decades interest rates will go up. This means a typical mid-to-long term government bond bought today in a developed country will provide a return that's roughly equal to inflation.

10-Year Treasury Yield - Source: Multpl.com

Will yields go even lower? Will they go negative? They might, but not for long. Investors and those who provide capital want a return on their money. Smart people don't want to keep cash in peanut butter jars in the backyard for long.

Corporate bonds provide slightly higher returns than government bonds over time. They are also more risky because corporations go bankrupt and fade into nonexistence. Corporate bonds are more correlated to stock returns than government bonds, so they are not as effective buffering your portfolio from stock market crashes.

Real Estate

In Canada residential real estate is priced at nosebleed levels in most major cities compared to the historical norm. In many places rental properties don't provide positive cash flow at current valuations.

If an investment doesn't cash flow after accounting for all costs, it's a crappy investment and you should stay away. Don't let the successes of real estate investors who got in the game a decade or more before you make you delusional. They have benefited from a huge bull market.

At current prices investing in residential real estate sucks. You are likely to face higher costs (particularly taxes and interest rates) while holding a declining value asset over the coming decade.

Portfolio Strategies

Every investor should be very aware of these valuation problems; that's why I'm sharing with you. Returns in a passive portfolio strategy are likely to be quite low going forward in the short-to-medium term.

If history is any guide, sometime in the coming years we are likely to see another 40%+ drop in the stock market. In the past, when we have reached these types of valuations, markets crashed. Wishful slow melts don't happen when markets are richly priced.

That doesn't mean you should sell your stocks and go hide, waiting for the next crash. But it does mean you should mentally prepare yourself for a big crash.

History shows that market crashes can be great buying opportunities. With the exception of 1931-1932, whenever stocks drop more than 20% for the year, they pop up more than 20% the following year. This is why re-balancing with bonds, gold, and new contributions works so well over the long run.

Another option is to follow a market timing investment strategy. Dual Momentum has shown fantastic results over whole market cycles because it does so well reducing losses during a market downturn.

A great advantage with Dual Momentum is you only need to look at your brokerage account once a month and most months you make no trades. It's about as easy as active investing gets and simplicity works well for most people if they can trust the system.

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