2013 Turbulent Teens
Risk and Expected Return Revisited - A New Hope*
*apologies to Star Wars
Ed Keon
Portfolio Manager
Joshua Livnat, PhD
Senior Researcher
Ed Campbell
Portfolio Manager
Joel Kallman
Portfolio Manager
Marcus Perl
Portfolio Manager
Marco Aiolfi, PhD
Senior Researcher
Yesim Tokat-Acikel, PhD
Senior Researcher
Rory Cummings
Analyst
For more information,
please contact:
Stephen Brundage
Product Specialist
Quantitative
Management Associates
2 Gateway Center, 6th Fl.
Newark, NJ 07102-5096
973.367.4591
www.qmassociates.com
January 2013
Introduction
When we started this Turbulent Teens (“TT”) series of white papers at the end of 2009, we
were undertaking a fool’s errand, attempting to predict the economic and market
environment of this decade. We acknowledged that no one can predict events, and that
some event not yet imagined could turn out to be the key driver of the global economy and
financial markets this decade. Yet investing is inevitably about the future, and so we plunged
ahead to offer a framework for possible economic and market outcomes, with thoughts
about the implications for investors and investment strategy.
The Turbulent Teens Through 2012
If we could characterize the tone of this TT series so far, we would call it cautious optimism.
U.S. Equity Market. We have consistently expected U.S. equity returns (as
represented by the S&P 500 Index) to be in high single digits. So far, that has been a bit
too conservative; after a strong 2010 and a flat 2011, and on the back of 15% in 2012,
annualized total returns this decade have been about 10%. Nonetheless, we are sticking
with our call of high single digit equity returns for the decade overall; so far, the
fluctuations around this expectation are well within historical averages.
 Europe. We have thought in these TT pieces that Europe would “muddle along” (TT
II) rather than collapse, because, among other reasons, it was in the best interests of
Germany to keep the union alive (TT IV). Although events in Europe have given
investors plenty of anxiety so far this decade, we continue to stick with our muddle
along call. Indeed, though many things can still go wrong, we would not be shocked to
see Europe regain a bit of positive traction before 2013 is out. Similarly, we considered
the possibility of a hard landing in China in TT IV, and argued that it was less of a risk
than others believed. While we cannot rule out the possibility of a shock from China in
2013, we think it is more likely that China will pick up a bit in 2013 from a relatively (by
China standards) weak year in 2012.
 New Energy. Although we were by no means the first to discuss it, our section in TT
IV titled “New Energy Developments Could Drive Growth” is on the fast track to
becoming part of conventional wisdom. Although environmental concerns remain, the
potentially positive impact of a rapid increase in U.S. oil and gas production through
“fracking” technologies has become a key part of the national dialogue. As we discussed
last year, the U.S. has shipped trillions of dollars offshore to buy energy since the 1970’s.
A slowdown of this outflow over the next few years and potential inflows from net
energy imports a decade or two from now could provide a big boost to U.S. exports,
employment, and GDP. It might also help rebalance global imbalances that, we argued
in TT I, had contributed to the causes of the 2008 financial crisis.
 U.S. Economy – A Glass Half Full? As we look at the U.S. economy, we see several
reasons for optimism. House prices are rising sharply in most of the country.
Employment and incomes are rising, albeit more slowly than we would like. Auto sales
are rising rapidly, and pent-up demand in other areas might start to boost economic
activity in 2013. Most of the concerns we hear are on the policy front. A deal was
reached to avoid the “fiscal cliff,” but some worry that negotiations over a debt ceiling
increase will roil markets in 2013. In our opinion, the fiscal cliff deal showed that
Congress can eventually reach agreement for the good of the country and will probably
do so again. Yes, taxes will rise in 2013; but as we discussed in TT I, the drag from this
might not be as big as some fear.

1
2013 Turbulent Teens
Risk and Expected Return Revisited - A New Hope*
*apologies to Star Wars
January 2013
If an investor had just listened to news and opinion reports from the left, right, and
center in 2012, she might have concluded that stocks would have been down, given all
the “uncertainty.” (Certainly the top investment buzzword of 2012.) Yet stocks have
delivered a 15% return. Call us crazy if you wish, but after being the center of attention
throughout 2012, we hope that D.C. will become more like professional referees by the
end of 2013, setting the rules, keeping the game moving, but letting the private players
drive most of the economic action.
If the consensus for economic growth in 2013 is about 2%, we will take the
“over;” that is, we think that 3% or greater real growth is more likely than 1% or
less.
Looking Ahead to 2013
In general, we think the story of 2013 will be that the trends of 2012 will continue. The
global economy will continue to make slow, occasionally halting progress, but progress
nonetheless. We are sure some shocks will come, but we suspect that earnings will grow a
bit, executives and investors will become a bit less fearful, and stocks will deliver solidly
positive returns. Sometimes the trend is your friend. Sometimes history does repeat. (For
example, the senior author of this piece re-experienced two things from his youth in 2012:
gas lines and a Rolling Stones concert.) So we think that the global economy in general will
look like a somewhat better 2012 in 2013.
Turbulent Teens V
In this edition of the Turbulent Teens, we will focus more on a quantitative investing topic
and less on current events. In each of these white papers, we have discussed the topic of
asset class valuation and expected returns. This year we will offer a new twist on this issue,
examining how risk is priced within the U.S. equity market.
In many ways, the history of asset prices has been action-overreaction-and counteraction.
The oil shocks and poor economic policies of the 70’s led to high inflation, high
unemployment, and very low valuations of stocks and bonds. The brutally effective counter
moves of the Fed and improved economic policies started the great bull markets in stocks
and bonds in the 1980’s. Alas, this led to an equity bubble, its bursting, a housing/credit
bubble, its bursting, and perhaps a sovereign bond bubble which might be in the process of
deflating.
Bearing Risk Might Be Rewarded in 2013
Similarly, we will argue in the pages that follow that, in addition to dislocations across asset
classes, investors might have adopted irrational pricing of risk among stocks. We will offer
evidence that investors paid a premium for risk in the 1990’s through the period leading to
the financial crisis. But we believe that this premium is gone now, and that riskier, higherbeta stocks now sell at a discount, as theory suggests they should. Indeed, we think that risk
became more rationally priced in 2012 than it had been in the prior two decades, perhaps
longer. This does not necessarily mean that stocks are cheap, though we think it is
supportive of that hypothesis. But we do think that there will be a positive relationship
between risk and expected return again, and that investment ideas that relied on the perverse
relationship between risk and return (e.g. low vol, low beta, risk parity, etc.) might not work
quite as well in the future as they have in the recent past.
2
2013 Turbulent Teens
Risk and Expected Return Revisited - A New Hope*
*apologies to Star Wars
January 2013
To fans of the previous TT pieces, this piece might seem a bit geeky compared to prior
editions. Yet, for real quant jocks, this might seem to be a thin gruel relative to academic
research. So why proceed? Because if we are right about the change in risk pricing, we think
this might have important effects on investing. If assuming risk starts to pay off again in a
way that it has not for the past three decades, based on the outperformance of Treasuries
versus stocks, we suspect that the outlook for equity markets and the economy over the rest
of the decade might be a bit brighter. Risk-taking has clearly been a bit out of favor in the
recent past. An excessive desire for safety can hurt economic performance almost as much
as an aggressive allegiance to risk-taking. We think that a healthy balance between safety and
risk, fear and greed, is most conducive to economic growth. And if we are correct that a
sensible relationship between risk and expected return has been restored, then we believe the
balance of this decade might be better economically than the first few years have been.
3
September 2012
behavioral finance didn’t really burst on the scene until the
1990’s. Both CAPM and FF assume that economic actors
are rational and that financial markets are reasonably
efficient. Behavioral finance eschews that assumption, and
cites many studies that demonstrate that manifestly
irrational behavior among homo sapiens is commonplace.
Humans are prone to a long list of mistakes: we are
overconfident in our own abilities, we tend to extrapolate
too much based on the recent past, et cetera, et cetera, et
cetera. Behaviorists believe that, due to our foibles, we
misprice assets. In time, these mispricings might be
perceived and corrected, but in the interim, savvy investors
can exploit the mistakes of others to earn returns.
What is the Expected Return of a Risky Asset?
What is the expected return of a risky asset? Several decades
ago, a simple, elegant theory that came to be known as the
Capital Asset Pricing Model (“CAPM”) arose to answer this
critical question.
CAPM was based on some basic, common sense ideas.
Risky assets should have a higher expected return than safe
assets, otherwise no one would hold the risky assets. But
investors should expect no return for exposing themselves
to unnecessary risks that could be easily avoided through,
for example, holding a diversified portfolio. From these
ideas, the architects of CAPM concluded that the optimal
portfolio of risky assets was the “market portfolio” of all
risky assets, and that investors should hold some
combination of this market portfolio along with the “riskfree asset” (long or short) to obtain a portfolio with a
desired level of risk and expected return. The leverage of
the investor’s portfolio combined with the market portfolio,
or beta, determined the expected risk and return.
Behavioral finance got a boost during the inflating and
subsequent deflating of the tech bubble. The FF model was
introduced in 1992, but from 1994 to 1999, growth stocks
handily beat value stocks and big stocks beat small.
Although FF saw some redemption starting in 2000, the
behaviorists offered a complex, technical explanation of
both the expansion of and bursting of the tech bubble:
humans are nuts. The tech bubble (and subsequent housing
bubble) was the latest manifestation of behavior that has
persisted for centuries, as documented by the work of
Kindleberger, Minsky, and others - most recently Reinhart
and Rogoff. In general, over time, asset prices might revert
to some rational model, but they can deviate from objective
value for years at a time. Any model that assumes
rationality, the behaviorists believe, can never fully account
for the many periods where markets seem clearly irrational.
The only trouble with this theory is that in empirical tests
over many years, lower-beta assets seemed to consistently
provide higher actual returns than the model predicted and
higher-beta assets have delivered much lower returns than
CAPM expected. A theory can withstand a few years of
“anomalous” results, but four decades is a bit much.
In 1992, Fama and French (“FF”) offered an alternative
way of explaining returns.1 Yes, they found, the return of
the market portfolio influenced returns of all risky assets,
but beta didn’t seem to matter at all. Instead, an asset’s
exposure to value (as measured by the returns to a portfolio
of high book value/price stocks minus the returns of a low
book/price portfolio) and size (measured by returns to a
portfolio of small minus large stocks) seemed to matter a
lot. FF offered no theory to explain their results, but they
offered a mountain of evidence across time and space to
support these initial findings.
Bearing Risk Did Not Pay (1981-2011)
As we write this in 2012, however, all the competing
schools of financial theory face a basic problem: in the 30year period ending December 31, 2011, U.S. Treasury
bonds provided both higher returns and lower volatility
than U.S. equities. Over the course of three decades, bonds
have simply dominated stocks; there was a negative payoff
for bearing the extra risk of stocks. If this were to persist,
there would be little rationale for the existence of the equity
market as currently constituted. Indeed, many investors are
acting as though this were in fact the case. Individual
investors have been big net sellers of stocks for more than a
decade. Some well-respected market observers have
recently declared the end of the “cult” of equities. The “risk
parity” notion that levered bonds offer a better risk-return
proposition than equities for at least a portion of the policy
portfolio has gained traction with many sophisticated
investors, and the results of products offering this idea have
been impressive in the past few years.
The lack of theory underpinning the FF 3-factor model
(and later, the 4-factor model, adding in Carhart’s
momentum factor) drew a spirited rebuke from Fischer
Black (“Estimating Expected Return”2), and to this day a
debate rages in academia over the relative merits of CAPM,
the 3/4-factor model, and other contenders to the asset
pricing throne.
One of those contenders is behavioral finance. Although
the roots of behavioral economics reach back to the work
of Becker, Kahneman, and Tversky in the 1960’s and 70’s,
1.
Eugene F. Fama; Kenneth R. French, “The Cross-Section of Expected Stock Returns,” The Journal of Finance, Volume 47, Issue 2
(Jun.,1992), pp427-465.
2.
Fischer Black, “Estimating Expected Return,” Financial Analysts Journal, September-October 1993
4
September 2012
So where do we go from here? To paraphrase Henry Ford,
is financial theory bunk? Is there a way of explaining the
market of the past that is NOT data mining, but that
instead provides a sensible guide to what might happen in
the future? We’ll offer the following ideas:
Supporting the behaviorists, we think that assets can be
mispriced because investors have a hard time assessing
the right price to pay for risks. In particular, investors
have found it difficult to differentiate cyclical growth
from secular growth, and investors have chronically
underestimated the impact of leverage.

We think that much of the mispricing of risk has been
corrected over the past several years.

We believe that CAPM will be a much better guide to
future returns than it has been to past returns, and that
investment strategies that are based on the notion that
historical patterns will continue into the indefinite
future might not work as well as hoped.
A few years of strong growth might very well be due to
cyclical economic exposure during a period of strong
economic growth. The growth might well be genuine, but
the economic risk exposure might mean that earnings will
turn down dramatically during a recession. True, superior
secular growth is worth paying a premium for, but it is rare.
Cyclical growth is fun while it lasts, but it is not worth a
significant valuation premium.
So if sustained growth is unlikely to be enough for stock B
to deliver triple the returns of slow but steady A, what other
possibility is there?
Figure 1
Expected Return

the 1990’s like Dell, Microsoft, and Intel delivered solid
growth for many years, but they have been much less
robust recently.
CAPM Strikes Back
Let’s start our investigation of this issue with a simple,
stylized example. Consider the Securities Market Line in
Figure 1, and imagine two stocks, A and B. Stock A has a
beta of 0.5, B has a beta of 1.5. Assume that the risk-free
rate is zero, that no dividends are paid, and that the
expected return on the market is 7%. That means that,
according to CAPM the expected return on stock A is 3.5%
and stock B has an expected return of 10.5%. How are
these expectations likely to be realized?
Stock
B
10.5%
7%
3.5%
Stock
A
0.5
1.0
1.5
β
Shown for illustrative purposes only.
Valuation?
Growth?
Well, at time zero, B might have a lower valuation (price to
earnings ratio, or “P/E”) than A. Assuming that both
stocks have earnings per share growth of 6%, pay no
dividends and have an initial stock price of $10, for B to
deliver the 10.5% average annual return over 10 years
consistent with its risk it would have to reach a price of $27,
while A needs only hit $14 to achieve the appropriate 3.5%
risk-adjusted return. If the growth is the same, then B
would need to have an initial P/E about half that of A.
This result seems strange to those of us who remember the
1990’s, when tech stocks had both premium P/Es and high
betas (see “The End of the Tech Mystique).4 But the logic
of our little thought experiment is compelling: unless highbeta stocks grow much faster than average for a long time
(unlikely), they must start at a low valuation to deliver the
appropriate expected return. If they do not have a low
valuation, they will probably deliver a return below what
CAPM predicts.
The most obvious explanation is growth, that stock B is a
high-flying tech company with a hot new product and A is a
plodding utility company, solid but slow. However, we
know that stocks discount the future, and not just the
immediate future. If growth is the sole explanation of stock
B’s superior expected return, B must grow at three times
the rate of A (and 50% greater than that of the average
stock in the market portfolio) for an extended period in
order to deliver on the return expected.
The trouble is, we know that sustained, superior earnings
growth is rare,3 not much more than can be explained by
chance. Basic economics suggests that great growth
opportunities will attract competition (or anti-trust
regulators), and that growth is much more likely to revert to
the mean over time than to persist. Environmental or
technological changes can catch growing companies short,
and new champions may emerge. Indeed, the PC heroes of
3.
L. K. C. Chan, J. Karceski, and J. Lakonishok, “The Level and Persistence of Growth Rates,” Journal of Finance, Volume 58, Issue 2,
April 2003, pp 643-684
4.
Ed Keon et al., “The End of the Tech Mystique,” Prudential Equity Group, LLC, September 7, 2004
5
September 2012
We already know from numerous studies over multiple
decades that high-beta names have historically had
disappointing returns and low-beta names have had better
returns than CAPM predicted. We argued above that the
odds of a high-beta stock delivering high returns are higher
if the initial valuation is lower than average. So, have highbeta stocks historically sported low P/E ratios? In a series
of pieces published by the late lamented Prudential Equity
Group in 2004, the senior author of this white paper and
his team at the time found that the answer is simply NO.
principles of Modern Portfolio Theory (“MPT”) was that
investors should not expect to be compensated for taking
unnecessary risks. But perhaps some misread the CAPM
chapter of MPT; investors did not automatically receive a
higher return from bearing greater beta risk, and they
should only rationally expect to receive a greater return if,
as with any asset, they had paid a sensible initial price.
Overpaying for any asset normally results in disappointing
actual returns.
Why did investors overpay for risk prior to 2008? In part, it
might be that they overestimated the sustainability of a
growth spurt, as discussed above. Another new/old
explanation first floated by Fischer Black in 1972, is
leverage aversion. Investors who are averse to leverage but
who have high risk tolerance and high return needs might
prefer to buy high-beta assets rather than borrow to make a
leveraged bet on the market portfolio. This behavior would
tend to artificially boost the prices (and by implication the
valuations) of higher-beta assets and suppress the valuations
of lower-beta assets.
Have Investors Been Paying a Premium for Risk?
In “Do Investors Pay a Premium for Risk?” (6/14/04),5 we
found that from 1992 to April 2004, investors had paid a
higher P/E for stocks with a higher beta. That premium
had been quite small in 1994, before the great bull market
of the 1990’s had started roaring, and had hit its highest
point when tech stocks peaked in March of 2000. This was
not just a tech stock phenomenon, however: we found a
premium P/E for higher beta across all sectors except
Materials and Energy. In “Further Evidence that Investors
Pay a Premium for Growth” (6/21/04), 6 we found that the
premium valuation for higher beta was not explained by
expected growth rates; that is, for stocks with slow,
medium, or fast expected growth, within each grouping,
higher-beta stocks had higher P/E ratios. A follow-up piece
on July 6 showed that premium valuations for higher beta
also applied (with some caveats) to other valuation metrics:
cash flow yield and book/price.7
Leverage Might Cloud Investors’ Minds
There is a related reason that higher-beta stocks might
have underperformed historically: investors might not
accurately assess how leverage impacts beta or growth. This
is perhaps most apparent for financial firms. Suppose banks
C and D both start with the same opportunity set (let’s say
they borrow at 3% and lend at 6%) and the same 10:1
leverage ratio. Suppose D, over time, increases its leverage
to 20:1. D is now clearly riskier; it should logically have a
higher beta and a lower valuation. An investor can add
leverage on their own if they so choose; the market should
not necessarily reward the bank for adding risk.
In many ways, the results of these tests should not have
been surprising. They were simply ways of quantifying what
was already well known in 2004, that historically high beta
stocks had delivered lower returns than CAPM had
predicted and low beta stocks had delivered better-thanexpected returns. These 2004 pieces offered a different
perspective however: maybe the problem wasn’t just the
theory, perhaps the issue arose from mis-pricing. That is,
perhaps investors had an irrational preference for high beta
that had led them to pay a premium rather than demand a
discount for assuming greater risks.
But in reality, the added leverage of D will roughly double
its earnings per share (“EPS”) unless the bank’s lenders
demand higher rates to compensate them for the added
risk. If EPS does double and the P/E is not cut about in
half, adding the leverage will result in a higher stock price,
and encourage adding even more leverage. Investors have
long recognized that higher leverage should cut valuations,
but in the decades leading to the financial crisis that lesson
seems to have been less than fully appreciated. In addition,
some institutions added leverage “off the books,” outside
the prying eyes of regulators, analysts, or investors.8
In a long bull market, that error had few negative
consequences; indeed, the rising market, especially toward
the end of the tech bubble, seemed to validate and confirm
the wisdom of making this mistake. One of the guiding
5.
Ed Keon et al., “Do Investors Pay a Premium for Risk?” Prudential Equity Group, LLC, June 14, 2004
6.
Ed Keon et al., “Further Evidence that Investors Might Pay a Premium for Risk,” Prudential Equity Group, LLC, June 21, 2004
7.
Ed Keon et al., “Additional Evidence that Investors Might Pay a Premium for Risk,” Prudential Equity Group, LLC, July 6, 2004
8.
Gillian Tett, Fools Gold: How the Bold Dream of a Small Tribe at J.P Morgan Was Corrupted by Wall Street Greed and
Unleashed a Catastrophe
6
September 2012
So in addition to underestimating the valuation hit
appropriate for higher leverage, investors might not have
known how much leverage was creeping onto financial
institutions balance sheets. A mispricing of risk (and a
contributor to the 2008 financial crisis) might have been the
result.
stocks had low price multiples, and higher-beta stocks
higher price multiples. As we showed in our example above,
it is very hard for high-beta stocks as a group to deliver
returns appropriate to their risks when they start with a high
P/E. Low-beta stocks, on the other hand, would get a
boost from their lower initial P/Es. If they grew earnings at
an average rate, or even a modestly slower than average
rate, they could still achieve returns higher than would have
been expected based on their low betas.
Do Investors Still Pay a Premium for Risk?
So far, we have presented some evidence that investors
might have mispriced risk in the past, and we have offered
some explanations of why they might have done so. The
question now is: do investors still pay a premium for risk?
In short, we think the answer is now NO; that is, we think
the market has largely corrected its error.
However, note from Figure 2 that the relationship between
earnings yields and betas changed in the wake of the
financial crisis in 2008/2009. High-beta stocks now sell for
lower price multiples; low-beta stocks now command a
premium multiple. Selected examples are presented in
Figure 3.
In Figure 2, we show the relationship between earnings
yield (“E/P”) and beta, based on the 3000 largest market
cap stocks in the U.S. We eliminated stocks with negative
earnings and other outliers. We calculated relative E/P
(“REP”) as E/P for each stock divided by the universe
average E/P. We then regressed REP on beta each month
and we display the resultant monthly regression coefficients
in Figure 2. (Note: we use earnings yield here for technical
reasons. We will revert to its inverse, the more familiar
“price multiple,” P/E, over the next couple of paragraphs.)
In August of 2012, Proctor and Gamble (“PG”) sold for
nearly the same P/E as it had during the height of the tech
bubble, 17x next year’s forecast earnings. But in 2000, that
represented a discounted P/E to the S&P 500’s 25.7x, while
today it represents a premium P/E to S&P 500’s 13x. PG is
now, as it has been in the past, a low-beta stock, generally a
steady, non-cyclical grower. Because it is safer than the
average stock, it should logically have a lower than average
expected return. With the premium P/E it carries today, it
seems to us that its future return is more likely to be below
than above average, as the CAPM theory suggests it should.
As Figure 2 shows, earnings yields and betas had been
negatively correlated prior to 2008. On average, low-beta
Figure 2
0.6
Relationship Between Earnings Yield and Beta
11/30/93 – 11/30/12
Regression Coefficient*
0.5
0.4
Above the line:
Higher Beta = Lower P/E
0.3
0.2
0.1
0
-0.1
Below the line:
Higher Beta = Higher P/E
-0.2
-0.3
Source: QMA, FactSet.
*Methodology: we show the relationship between earnings yield (“E/P”) and beta, based on the 3000 largest market cap stocks in the U.S. We eliminated stocks with negative
earnings and other outliers. We calculated relative E/P (“REP”) as E/P for each stock divided by the universe average E/P. We then regressed REP on beta each month. Of
note: we use earnings yield in the data for technical reasons. We revert to its inverse, the more familiar “price multiple,” P/E, in the explanations.
7
September 2012
about equal to the historical average. We have argued since
we started the TT series in 2009 that the expected return on
the S&P 500 is in high single digits. That’s a bit less than
the historical nominal return, but about equal to or slightly
above the historical excess return in today’s low rate
environment.
Figure 3
Forward P/Es: 2000 vs. 2012
Procter &
Gamble
P/E
Beta
Cisco
S&P 500
August 2012
17.0
9.8
13.0
March 2000
16.9
126
25.7
August 2012
0.3
1.4
1.0
March 2000
0.9
1.3
1.0
So if Risk is Priced Correctly Today, What Should
Investors Do?
So what does this suggest that investors might do to
position themselves for the future? Our first suggestion is
that investors should not overly rely on the past few
decades for guidance. As we showed in past TT, in the 30year period ending in 2011, Treasury bonds had higher
returns than stocks, despite their greater safety and lower
volatility. If investors had known that 30 years ago, they
would have sold stocks and bought bonds. If safe assets
outperform risky assets, then risky assets must have been
overpriced, or safe assets had to be underpriced, or both.
But in the past dozen years, stocks have gone from all-time
record valuations to roughly average valuations, while
bonds now sell for near record-low yields, record-high
valuations. Assets like commodities have defied their longterm pattern of negative real returns to deliver exceptional
returns over the past decade. TIPS sell for a negative real
yield. We think a change in environment is more likely than
a continuation of these recent historical trends.
Source: QMA, FactSet.
At the peak of the tech bubble, Cisco sold for an
improbable but true multiple of over 100x forward earnings
despite its high beta. Its beta is about the same as it was
then, but the P/E has tumbled to under 10x, a discount to
the S&P 500. We can offer no rational explanation of what
investors were thinking in 2000, but today’s multiple seems
about right for a high-beta name like Cisco. Further, we
would suggest that the closest equivalent to the Cisco of
2000 in 2012 is Apple. Both had huge market caps, a
dominant market position, and a multi-year record of
superior sales and earnings growth. But in the market of
2012, Apple sells for about a market P/E. Indeed, concerns
about Apple’s future growth prospects in the fall of 2012
contributed to a significant correction to a forward P/E
below the overall S&P 500.
It might seem odd for quants to argue that backtests that
rely on the past few decades might offer a misleading guide
to the future; backtests are a lot of what quants do. But
backtests are intended to discover historical trends that
might persist in the future. If some of these major trends
reverse, the consequences might be profound. Consider
that, in the 1990’s, reasonable people argued that investors
might consider investing 100% in equities. In 1999, some
folks bought tech stocks on margin, a practice that had
delivered huge returns over several prior years. In 1972,
folks snapped up Treasury bonds yielding 6%, a yield that
looked quite rich by historical standards given the low rates
of inflation that had been experienced on average for the
prior four decades, only to see inflation soar and bond
prices crash over the next several years. By 1981, it took
yields of over 13% to induce investors to buy Treasuries, a
record-high yield that set the stage for the three-decade
bond run that we think is near an end. That does not mean
to imply that backtests are useless today, but it suggests to
us that caution is needed. Are the results truly indicative of
a market opportunity, or is an apparent anomaly a function
of the environment in which it was measured? It is never
easy to answer that question, but we suggest that it might
be especially difficult today.
In short, whatever their motivation, we think that there is
good evidence that in the past, investors paid a premium
for risky stocks. However, we think there is also evidence
that the market today has changed, motivated in part by the
financial crisis of 2008 and its aftermath.
We offer a simple way of summarizing the cause of the
crisis: too many players took too much risk. Minsky was
right; several decades without a major crisis had convinced
economic actors that risk-taking was a free lunch rather
than a prelude to potential disaster. We suggest that
whether it was within the U.S. equity market, on bank and
household balance sheets, in global real estate portfolios, or
in many other human endeavors, economic factors assumed
too much risk. It ended badly.
But it seems to us as though markets have learned a
valuable albeit painful lesson from the crisis. Prices have
substantially adjusted. Low-beta names now have premium
P/E ratios, and high-beta stocks sell at discounted P/Es.
We do NOT think that means that risky assets are
especially cheap. Indeed, the overall market P/E looks
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September 2012
Figure 4
Expected Return
Might the future resemble theory more than the past?
Historical Higher β =
Higher P/E, Higher Exp.
Growth , negative alpha
Now, Higher β stocks = Lower P/E
Historical Reality
Historically, Lower β =
Lower P/E, positive
alpha
Today, Lower β stocks
tend to be Higher P/E
1.0
β
Source: QMA. Shown for illustrative purposes only.
Back To Theory
significantly improve diversification while delivering an
acceptable level of risk-adjusted expected return.
We think it might be time for investors to revisit what
Fischer Black called “the almost-clear waters of theory.”
(See Figure 4.) We might summarize the CAPM theory by
saying that only a fool takes on extra risk without a
reasonable expectation (as opposed to a vain hope) of an
excess return. Risk-takers do not deserve an extra return
simply because they have taken on risk. Even if they have
carefully analyzed their decision in advance and have taken
on a very sensible risk, events might mean that actual
returns are poor; that’s why they call it risk. But the odds of
achieving appropriate risk-adjusted returns are high only if
the initial price is right. Overpaying for risk can work in the
short run if there are greater fools about. But it’s a mug’s
game. Risk will only consistently deliver acceptable returns
if the price is right, which we think it is today.
Final Thoughts
Note that we have not changed our title this year to
“Tranquil Teens.” We do not believe that the problems of
the world have been solved and all is clear. We remain
worried about U.S. politics, European stability, China, the
Middle East, and other hot spots of various types around
the globe. The effects of the financial crisis still linger, and
we could still relapse. And we remain worried that in a few
years, the labor market might tighten (yes, you read that
right) to the point where inflation might become a problem.
But we do not think that is a 2013 worry; we will probably
ponder that and other demographic/economic issues a bit
more in next year’s TT.
We think, however, that somewhat quietly, below the
surface, markets have adjusted since the financial crisis in a
healthy way. During the crisis, we experienced the perils of
excessive risk-taking, and perhaps recognized that
complacently adding risk in the blithe expectation that
higher risk will always result in higher returns is a terrible
mistake. As we noted earlier in this paper, markets have a
history of under- and over-reacting. The relative calm of
markets in the 1980’s and 90’s set the stage for excessive
risk-taking, and events in the past decade have wrung that
recklessness out of the system. That suggests that we can
absorb shocks better now than we could in 2008, and that
we are in an improved position for more robust growth
than we have seen so far this decade. In short, despite the
“fiscal cliff” and so many worries of the day, we enter 2013
more optimistic than we have been since the start of the
Turbulent Teens.
So if risk is priced right, there’s no need to reinvent the
wheel. Our betters figured this out several years ago.
Investors should hold a combination of the risk-free asset
(say short-term T-Bills) and the market portfolio of risky
assets. We could get into a long discussion of what should
constitute the market portfolio, but let’s just keep it simple,
favoring the most liquid risky assets with the lowest
transaction costs: stocks. Our portfolio should be global,
and include developed, emerging, and probably frontier
markets. It should include large and small caps. We might
start with market cap weighting, but we would guess that
some reasonable tilts based on other factors (smaller caps
perhaps, or value or momentum, or maybe prospects
outside the usual suspects) might be helpful. We might also
want to add risky assets other than stocks (e.g. real estate,
corporate bonds including high yield, commodities, hedging
instruments, etc.) if we reasonably believe that they will
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September 2012
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