September 12, 2014

With the stock market trading near record highs should investors adjust their portfolios? David Darst and Jay Kaplan say yes! Darst is an independent investment consultant and Senior Advisor and member of the Global Investment Committee at Morgan Stanley. He is also the author of 11 books, including two on mastering the art of asset allocation. Kaplan is portfolio manager of several funds run by small cap pioneer, The Royce Funds, which is known for its value orientation and high quality company focus. We’ll get their personal perspectives on market valuations.

This week on WealthTrack, what do high altitude markets mean for portfolio selection? Asset allocation master David Darst and small cap fund champion Jay Kaplan discuss the routes they are taking to stay at peak performance in pricey markets. They are next on Consuelo Mack WealthTrack. Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack.

We don’t pay too much attention to daily, weekly or even monthly moves in the markets on WealthTrack. As JP Morgan once quipped “the market will fluctuate!” And so it does and will. We do however look at longer term data to determine how expensive or cheap stock prices are and one of the best guages that we have seen is the creation of Nobel Prize winning economist Robert Shiller and a colleague, John Campbell. As WealthTrack viewers know, Shiller, a frequent WealthTrack guest is a professor of economics at Yale, while Campbell teaches at Harvard. More than 25 years ago they collaborated and created what they called the “Cyclically Adjusted Price- Earnings Ratio, or CAPE Ratio. What the CAPE Ratio does is divide the current price of the market by inflation adjusted corporate earnings averaged over the prior 10 years instead of the traditional P/E where the denominator is current earnings. According to Shiller the ten year history helps “minimize effects of business-cycle fluctuations” and is “helpful in comparing valuations over long horizons. “ Over a year ago Shiller warned that the CAPE Ratio stood at around 23, far above its 20th century average of 15.21.

In a column in The New York Times last month Shiller noted that the cape was above 25, “a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.”

As Shiller was quick to point out the CAPE was never intended to indicate exactly when to buy and sell. It’s been a very imprecise timing indicator and in fact has been relatively high, above 20 for almost all of the last 20 years. But here’s the Shiller kicker, over the last century the CAPE has consistently reverted to its historical mean of around 15.

It fell as low as 13.2 in the midst of the financial crisis.

This week’s guests are more than aware of how expensive the markets have been and are adjusting accordingly.

David Darst is an independent investment consultant and senior advisor and member of the global investment committee at Morgan Stanley. For 17 years he was the Chief Investment Strategist of Morgan Stanley Wealth Management. He is also the author of 11 books including two on mastering the art of asset allocation. Jay Kaplan is a Portfolio Manager at small cap pioneer, The Royce Funds which is known for its value orientation and high quality company focus.

Kaplan manages several Royce funds including Royce Value, and he is a Portfolio Manager for Royce Total Return and Royce Dividend Value funds with small cap legend Chuck Royce as Lead Portfolio Manager.

I began the interview by asking Darst about his personal perspective on market valuations.

DAVID DARST: I think we’re relatively late in this party, this bull market phase. You’ve got several indicators of valuation which would tell me that this is not the … If a party goes from six o’clock until midnight, this is not seven or eight o’clock. This is more 10 o’clock-ish or even after that. You’ve got four big, long-term valuation indicators. One is you’ve talked about many times the Cyclically Adjusted Price Earnings Ratio which is the Professor Shiller ratio, it’s 50 percent higher than the normal, than the long-term average. Secondly, you have the market capitalization to GDP ratio. It is double the GDP of the United States right now. It has never been this high except three times before 1929, before 2000, the big crash then and in 2007 before the crash then. Price to sales is 1.67 times sales. The long-term average is half that. It is double the long-term average, price to sales. You can’t mess around with sales like you can with earnings and, finally, what’s it called? The Tobin ratio, the Q ratio which is price to replacement cost. It too is very elevated. So on a long- term basis, people talk about price the next 12 months, earnings. That’s fine. It’s in the zone, 15, 16 times earnings, but on a long-term basis, Consuelo, but the drivers of asset prices for thousands of years are fundamentals, valuation and psychology, and the time to really leave the party is when the psychology gets too ebullient and too optimistic. We’re not there yet. This valuation abnormality, this valuation anomaly can continue until people all get pulled into the party. Then it’s time to leave the party.

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