Hesiod is considered the world’s first economist. He lived in the foothills of Mount Helicon near the Gulf of Corinth in the eighth century BC and was a contemporary of Homer. His Works and days is the most significant historical source on Greek farming techniques and the ancient economy. Hesiod’s advice still echoes down the ages: “Observe due measure, for right timing is in all things the most important factor.”
Timing, however, is something that is neglected, even abjured, in the investment world. Most pension funds set in stone a strategic asset allocation policy that allows little flexibility to exploit tactical market opportunities. Retail investors are told ad nauseam by (sometimes self-serving) financial advisers that they cannot time the market.
The experience of two great British institutions tells a different tale. The Church of England traces its history back to the Gregorian mission of 597 AD. In spite of Henry VIII’s depredations during the Reformation the church has traditionally been a secular as well as religious power in the land. Until relatively recently most of its wealth was held in land, but of late it has diversified into liquid financial assets.
Buildings and people
The Church Commissioners oversee a portfolio of approximately £3.9 billion from which they must pay for the upkeep of 16,000 church buildings and 43 cathedrals that many regard as England’s greatest architectural glory. Another body, the Church of England Funded Pensions Scheme, oversees the retirement benefits of the clergy.
Clare College is part of the University of Cambridge. Founded in 1326, it is rather less venerable than the Church of England, and other Cambridge colleges such as Trinity and St John’s are grander in scale and richer. Clare has a modest endowment of £60 million ($92.4 million). This pales beside the billions of Yale and Harvard.
These two US Ivy League universities have also won the laurels for their investment acumen, at least until recent times. Their strategy of being heavy in hedge funds and alternatives has been much imitated. The same cannot be said for the investment policy of the Church of England. In 1998 its pension scheme made the bold decision to invest 100% of its assets in the stock market. After a lost decade for equities it now has liabilities that require divine intervention.
Clare College, on the other hand, has been a trailblazer. In January it was announced that the Wisconsin Investment Board would use leverage. Other US public funds are said to be examining the idea. Clare got there first. In 2008 it borrowed £15 million via a 40-year inflation-linked loan, in effect leveraging itself to 125%.
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“Observe due measure, Hesiod |
It put some money to work in equities in October 2008 following the collapse of Lehman Brothers when the S&P500 was trading at levels last seen in 2002. At the time it was reported that the wise custodians of Clare’s capital were waiting for the index to fall below 700 before they went all-in. On March 9 2009 the S&P500 closed at 676. It now trades above 1100. History was always on Clare’s side. Robert Shiller is best known for predicting the technology, telecoms and media bust in 2000 and warning of a real estate bubble in the mid-2000s. In 1981 he developed a price/earnings ratio that allowed for the long-run comparison of equity prices by stripping out the effects of cyclicality. This approach has been adapted and refined by my equity research colleagues at State Street Global Markets.*
Using this P/E ratio it is possible to say whether equities are historically overpriced or underpriced and to compare what the outcome would have been for an investor who had bought the market at different points. As a gauge of relative valuation 1.65 standard deviations from the long-run mean is used to assess whether markets are cheap or expensive.
Dramatic divergence
Unsurprisingly the subsequent performance of markets diverges dramatically. There have been 24 periods of high cyclically adjusted P/Es (standard deviation from mean greater than 1.65) since the 1880s. In the next 20 years, a reasonable investment horizon for a pension fund or endowment, the average return from equities has been 47% (an annualized return of just 1.95%). On the occasions when the cyclically adjusted P/E has been 1.65 standard deviations below its historical mean the average 20-year return following has been 431%.
It is possible to play around with the standard deviation and the time period that is measured. However, the results are the same. Buying the market when it is cheap yields much better results than buying when it is expensive. The problem remains that buy low/sell high is an easy mantra to repeat but psychologically difficult to live by. However, the notion that you can’t time the market is simply cant. Hesiod and Clare College got it right. The Church of England did not.
* Special thanks to Benjamin Jones for help in the preparation of data
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own
