INDIAN EQUITIES STILL PRICED RIGHT FOR MEDIUM-TERM INVESTORS

IN MY VIEW, 10-YEAR COMPOUNDED ANNUAL REAL RETURNS SHOULD BE ABOUT 8% WITH AN UPWARD BIAS

On December 7, 2008, I held the opinion that Indian equities were attractively priced for investors with a medium-term horizon (SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS). I point that out not to stake my claim for predicting the breathtaking Q2 2009 rally, but to highlight that buying at the right price is key to investment success.

Short-term returns are driven by ebbs and flow in risk appetite. Such moves can be hard to predict even for the most seasoned market watchers. Over longer-term however, valuation plays the dominant role in determining returns. Sharp valuation downdrafts are good entry points for investors willing to bear near-term volatility.

EQUITIES STILL PRICED TO BEAT BONDS OVER 5 to 10-YEARS

In my previous piece, I had valued the SENSEX based on a price to nominal GDP multiple. Viewed from the same lense, equities are no longer under-valued. Yet, the asset class is not exuberantly priced either. From current levels, investors could garner at least 8% real returns over the next 10-years. This forecast assumes mean historical valuations and real GDP growth of about 7% to 8%. Needless to say that this projection builds in a margin of safety.

Yet, we must invest fully cognizant of the fact that over the short-term there could still be another downdraft.

FINANCIALLY ENGINEERING AN "ALL-WEATHER" EQUITY PORTFOLIO

In principle, any asset class or security can be levered up/down to create the desired risk return payoff. Based on this concept, two negatively correlated securities can be combined to achieve a given level of expected return with lower risk (defined in terms of standard deviation). Using this paradigm, I seek to configure a portfolio with the expected return of equities, but lower standard deviation: the "all weather equity portfolio".

Treasury yields/prices and equities are positively/negatively correlated (see exhibit 1). This property is particularly helpful in creating the "all the weather portfolio". During the 20th century, U.S. stocks and bonds generated yearly real returns of 6.7% and 1.6%, respectively. Assuming 2% inflation going forward, I construct the portfolio as follows:

1. Long U.S. Treasuries: 1.25
2. S&P 500: 0.5
3. Borrowing: -0.75

Effectively, I buy U.S. Treasuries on leverage to achieve equity like returns. I used ETFs to conduct this exercise for the period July 30, 2002 to June 11, 2009: TLT: + 20yr Treasuries and SPY. I assume leverage at 8.5% (the margin rate for a personal investor). Institutional investors can finance the bond portfolio cheaply in the GC-repo market. Finally, the portfolio is rebalanced every day.

The performance of the portfolio can be observed in exhibit 2. Importantly, while the S&P 500 rose about 5% during the period under consideration, the all weather portfolio was up 11%. At the peak of the price appreciation cycle, stocks were up about 74%, while our financially engineered portfolio climbed only 42%. This under performance in the bull market is a function of the high interest rate I used for assuming leverage. Interestingly, the all-weather portfolio reached its peak with 62% total return in December 2008 – a time when the equity only portfolio had failed to generate any return since inception.

Redoing the calculation with the GC-repo rate (average for the period: 2.54%), I get more favorable (and more realistic for institutional investors) results (see exhibit 2). In this case, the all weather portfolio keeps pace with equities in the up move, and protects downside during the market crash of 2008.


Exhibit 1. Positive Correlation: U.S. Equities vs. U.S. Treasury Yields



Exhibit 2. "All-Weather" Portfolio Performance: Institutional



Exhibit 3. "All-Weather" Portfolio Performance: Personal



Exhibit 4. Daily Return Statistics




Geek Notes

For calculating the total returns of the all-weather portfolio, I used the average yield on the 30-year U.S. Treasury as a proxy for coupon. And, I credited this coupon return on a daily basis. This implies that the returns on the all-weather portfolio are somewhat over-stated due to daily compounding.

Source: Bloomberg
Dimson, Staunton and Marsh; Triumph of the Optimists
Bridgewater Associates