My Benchmarks - Checking The Efficacy

In the latest blog, I had shared (my) benchmarks for checking broader markets overvaluation or undervaluation status.

Before I proceed to check the efficacy of these benchmarks, why do we really need such benchmarks?

Here let me quote the timeless advise rendered by Benjamin Graham in his investment classic – “The Intelligent Investor”:

We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50–50, between the two major investment mediums. According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high.

 

The need to establishing benchmarks, however imperfect they maybe cannot be defined more aptly that above comment made ages ago. Do note the phrase “judgement of the investor”.

That done, let us circle back to checking how benchmarks have fared historically.

First, on the higher side. If one thinks markets are overvalued, then natural expectation is returns going forward, at least on short term basis will not be that great. Let us say if next 1 year returns are less than 9% (higher end of 10 year government bond returns), we would consider markets have underperformed. Starting FY 2007, there were four periods when 3 period smoothened 10 year CAGR exceeded 18% annualized. Next 1 year returns for two periods were below 9% and the other two were comfortably above 9%. In fact, above 18%

Now, checking the efficacy of benchmarks on lower side. If the opinion is markets are undervalued, the expectation is, going forward, markets are going to deliver superior returns, even in short term. Let us say if next 1 year returns are above 18% (double the higher end of 10 year government bond returns), we will consider markets have delivered excellent returns. Again, starting FY 2007, there were, again four periods when three period 10 year decadal returns were less than 12%. Next 1 year returns, again for two periods were comfortably above 18% and the other two way below 18%. In fact, below 10%.

While four data points (statisticians are of the view at least 30 data points are required) are way too less to confidently confirm or reject the efficacy of benchmarks, still we have some numbers to consider. By strange coincidence, we have 4 data points on both higher and lower side of market performance. The numbers we have seen tell us that these benchmarks work 50% of times. The other way to look at is these benchmarks fail 50% of times.

Key question: Do we act on these benchmarks and adjust our allocation? That decision is left to every individual – circle back to “judgement of the investor” phrase!!! My decision – I would not mind being defensive when markets are high per my benchmarks.