When a fund manager recently visited and touted their emerging market bond fund as a good investment, we couldn’t believe what we were hearing.  The fund was 17% invested in Nigerian bonds, 9% in Russian bonds and 7% in Venezuelan bonds.  For that much risk, the fund had a yield of only 5.5%.  In our opinion, investors in that fund are not getting paid commensurate to the risk they are taking.

With the stock market, no one can tell for certain when the market is at a peak or at the bottom.  But what we can do is measure the risk of the market at certain points and, based on that risk, determine if we are getting an expected return on our investment to justify the level of risk being taken.  In 2009, the risk of being invested in the stock market was worth the expected return and it was a great time to be more heavily invested in stocks.  Back then, risk was low, especially considering expected return.  Things are different today.

What is the risk in the market today?  To many, the market “feels” ok.  A more tangible indicator we use to measure risk is the Shiller cyclically adjusted price/earnings (“CAPE”) ratio.  Below is a chart that shows the subsequent 5-year annualized return of the stock market at different CAPE ratio levels.  The current CAPE ratio is 25.90.  Historically, stocks have earned a 2.7% annual return over the following 5 years when the CAPE ratio is this elevated.  For such a nominal return, the risk of being heavily invested in equities is not justified in our opinion.  This does not mean that the market is going to fall precipitously.  It does mean that over the next 5 years, there is a higher probability that returns from stocks will be below normal.

What does this mean for investors?

First and foremost, diversification is important when risk is elevated in the stock market.  Second, we are looking for investments that offer a good risk/reward tradeoff.  If we are going to take more risk, we expect to get paid for it and therefore expect to get a higher rate of return.  We are currently finding good risk/reward investments outside of US stocks – emerging markets, MLP’s and non-traded REITs to name a few.

Book of the Month – The Global Minotaur, Yanis Varoufakis 

We get asked from time to time about books we think are timely and well written.  Each month we will attempt to highlight a book we think you might enjoy.  Please let us know if you find this of interest.

Too many times in America, we hear economic theories that are convenient for a certain political agenda.  This month, we highlight an economic book that offers a unique perspective on the economy.  The book is written by a Greek economist that looks at the economy on a world-wide basis.  He gives a history of how America put the world on great economic footing shortly after World War II with the Brenton Woods Agreement only to destroy it with the Vietnam War and the elimination of the gold standard.  This created the economic uncertainty around the globe in the 1970’s.  The stability provided by the implementation of the Brenton Woods Agreement was replaced by what he calls the Global Minotaur of the US dual deficits (trade and budget).  He espouses that the Minotaur died in 2008 and the world needs a replacement “global surplus recycling mechanism.”  An interesting, timely and thought-provoking book if you are so inclined.

Interesting fact – In 2008, Spain had a debt level lower than Germany.

Source: pinterest.com