Investors face the most challenging period in living memory

Traders take orders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange (CBOE) in Chicago, Illinois.
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Traders take orders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange (CBOE) in Chicago, Illinois.

"What assets should we invest in for the next five years and what returns should we expect?" was the straightforward question posed by the moderator during an entertaining panel discussion at an event I participated in this month.

Some of the answers given were anything but straightforward reflecting that the investment outlook today is perhaps the most challenging in living memory. For the last four decades, five-year investment returns have been relatively consistent from period-to-period. With the unprecedented levels of real return available from most asset classes during this time, it has served to make asset allocation far easier than it might be in the years ahead.

History has taught that a particular asset class exhibits reasonably consistent return expectations over time:


The best data I'm aware of are the valuations compiled by the Amsterdam authorities for Dutch property tax purposes, dating back to 1628. The message is clear; although values may depart from the trend by quite a significant variance for sustained periods, ultimately property - while also producing rental income - has increased in price over the very long term roughly in line with the rate of inflation.


Everyone knows that equities produce better long-term real returns than other asset classes such as property. Maybe everyone's wrong? If we adjust today's DJIA for inflation, that would be equivalent to a level just below 2,000 points when the index was created. Despite the recent volatility the Dow now sits above an impressive nine times that level. In other words, stocks would have to fall by almost 90 percent to mean revert (as they did the last time that they were as overvalued as this in the late 1920s).


The interest rates on government debt also tracked inflation extremely tightly for a significant period until the early to mid-1980s when rates negatively diverged (i.e. became much lower than inflation). This of course resulted in the prices of bonds increasing correspondingly.

Some believe that a structural adjustment took place during the 1970s and 1980s that justifies the divergence from centuries of data. Personally I don't – which means that we should expect to see property fall in value by up to 70 percent while equities fall in value by up to 90 percent.

But even if the structural adjustment argument is right and the clock had been re-set at the start of 2001, then over the next 15 years this would imply:

1) Property to do little better than remain flat in nominal terms and lose over 20 percent of its inflation-adjusted value.

2) U.S. equities to increase by around 2 percent per year in nominal terms and pretty much go nowhere in inflation adjusted terms.

3) U.S. 10-year Treasury interest rates returning to over 5 percent.

The ranges between best and worst cases for property, equity and bonds imply limited or no upside in the best outcomes and appalling downside in the worst. Buying and holding any asset class just isn't an option any more.

The scale of downside volatility looms so large that it should be seen as an opportunity to generate returns not just a threat that portfolios have to be protected against.

Trend following or CTA (commodity trading adviser) funds tend to exhibit uncorrelated returns in markets where equities, commodities or property go up in value (i.e. sometimes they go up too, sometimes they don't). But they exhibit extremely strong negative correlation when these asset classes crash.

Other risk-adjusted attractive propositions include equity funds that mitigate the risk by some form of insurance.

Although treasuries look to have a bleak long term future they do provide diversification against equity risk and at current yields of around 1.7 percent on the 10-year, they do have short to medium term upside potential. As does a weaker sterling – Vanguard's sterling-hedged U.S. Government Bond Index Fund is a great way to insure against a weaker dollar stemming for more dovish than expected Federal Reserve. Gold has also fallen back to levels where it would benefit from a backtracking Fed.

The risk and reward of all asset classes is a constant state of flux but arguably never so violently as now. A fixed allocation today to a winning 5-year strategy may not be possible without taking excessive risk. But a strategy built on today's pricing where most asset have asymmetrical risk/reward profiles (much more downside than upside) means that investors need to combine non-traditional investment strategies and methodologies with a constant ever-changing lookout for assets whose pricing - like gold, Treasurys and sterling right now - may be at or approaching something much more like fair value. Thus, making that risk/reward outlook at least more symmetrical, if not actually skewed in your favor rather than against you.

—Paul Gambles is a managing partner at MBMG Group.

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