04 Mar Valuation, Price Trends and Volatility To Guide Asset Allocations

There are 3 important factors to guide my views on asset class allocations and to sniff out some opportunities in global markets.

These 3 factors are Valuation, Volatility and Price Trends. Valuation is a good indicator of long-term returns while Price Trend is helpful for guiding my short-term view (of less than 1 year). Low volatility is a helpful indicator for above average risk-adjusted returns over the long term.

Valuation is a timeless concept and would adapt to suit almost any regimes. There have been numerous empirical investigations and conclusions to show the merits of basic valuation measures on both Equities and Bonds. Basic valuation measures include Cyclically Adjusted Price to Earnings for Equities and Current Yield relative to consensus GDP for Bonds.

A related concept which should be briefly discussed here is the difference between investing in the “market” and investing in individual securities or companies. When we invest in “markets” instead of individual companies, the idiosyncratic risk is broadly diversified. There is much lesser chance of the “market” going into prolonged depression and “bankruptcy”. To put it in another manner, a cheap company may be “cheap” for a long time and eventually goes out of business. A cheap market has much lesser chance of being “cheap” for a prolonged period.

Borrowing a famous concept from Benjamin Graham, buying into markets when valuation is in our favour provides a decent “margin of safety”. Valuation plays take time to work out and typically we are looking at 3-5 years.

For shorter time periods, it is helpful to look at price trends. Opportunities are present when the cheap markets are starting to trend higher.

The third factor is volatility. Over the last 2 years, more fund managers are launching Low Volatility Equity Funds, based on the low volatility anomaly. Research in recent years has shown that stocks with lower standard deviation (risk) tend to outperform stocks with higher standard deviation. The low volatility anomaly seems persistent and there are many papers describing it. It seems that a better time to increase exposure to equities is when volatility is low. (I’ve not read any research on the application to any other asset classes and I do wonder if it applies.)