Introduction 

What's Changed?

Global Price to Earning Ratios

Star Capital produces this valuation map of the world (below). 

The expensive regions are in red and the cheap regions are in blue.

The valuation measure we're looking at here is a cyclically adjusted price to earnings (CAPE) ratio developed by the Nobel laureate Robert Shiller.

What the CAPE measure tells you is the number of dollars people are willing to pay for every dollar of earnings generated over the last decade. The earnings in the denominator are averaged over a decade because that roughly corresponds to one business cycle. It also irons out the volatility of earnings which tend to fluctuate up and down a great deal from year to year.

The three maps below are how things looked in September 2017, May 2018  and March 2019.

The final map (below) is from September 2019. 

What's notable is that the U.S. is still very expensive, it's still one of the most expensive regions in the world. 

The UK is still cheap, largely because of Brexit uncertainty. 

Europe is also relatively expensive, whereas Russia remains very cheap due to concerns about sanctions against them. Japan is also quite expensive.

The reason why I look at cyclically adjusted price ratio is that looking a decade into the future, it is one of the best predictors of equity return.

In the graph below, the numbers on the y-axis are how much of the variance of stock prices is explained by each of these factors.

You can see that the Shiller ratio comes out top, but only for decade ahead returns, not for one year ahead, which is much less predictable. 

Even the price of stocks today divided by earnings over the previous year, which is  labelled P/E1, is also quite predictive of returns over the coming decade. But unsurprisingly rainfall isn't very predictive, so anything that's to the right of this is essentially noise.

This is far from a very accurate forecast. There's still a huge amount of uncertainty about what equity prices will do even though we do look at the CAPE measure. Currently we are at a CAPE multiple of just under 30. 

You can see in the diagram below, that there is a huge variability in the return of stocks over the following decade.

What you can see is that when valuations are very high, which is where we are now, returns tend to be lower than they are when valuations are low at a multiple of around ten. 

If we look up the average return over the next decade, when valuations are this high, it's only a little bit above zero on average.

Purchasing Managers Indices

Another factor I like to look at are the Purchasing Managers Indices (PMI).

When these are above 50 it signals expansion and when they're below 50 its signals contraction. 

In the Euro Zone, the last time that I looked at my portfolio these were falling very sharply which was a cause for concern. Whereas in the U.S. the PMI indices were holding up quite well and the composite index was still above 52.

What has happened since then is that the European PMI has fallen further and is now just on the cusp of falling below 50. Even the U.S. PMI, which until that point was very strong, has deteriorated significantly and it's now 51.2 as of October 2019.

You can see that while we are still in expansion territory, it's certainly weakened.

A weaker PMI index is a headwind for GDP growth and a headwind for GDP growth is generally a headwind for corporate earnings and for equity prices.

Therefore overall the picture for equity is looking a little bit worse than it was last time I updated my portfolio.

A perpetual worry for investors is that China is going to slow down. But you can see below that the Chinese PMI is actually okay. It is 51.9 as of September 2019.

China’s  manufacturing PMI increased to 51.7 in October 2019. What is positive about this is that the orders placed with companies improved substantially in October, despite the Sino-U.S. trade war. 

It's not all a rosy picture because business confidence has been weak and the employment sector continued to contract.

However, a big support for the Chinese economy has been large infrastructure projects and  it's very strong export market. So I'm not particularly concerned about China being a tail risk at the moment.

If we look at the kind of infrastructures which are helping the Chinese economy, the roll-out of 5G which is happening this month is a great positive.

So far it's only been rolled out in the largest cities. Large in China means really large! So Shanghai, for example, is 24 million people, that's almost three Londons.

What's incredibly important is the collaboration between business and government in rolling out this infrastructure. According to the mobile telecoms organisation GSMA, China will have about 40% of the total global 5G connections in 2025.

Policy

On the October 30th the Federal Open Markets Committee, which decides U.S. interest rates, reduced rates for the third time in 2019.

The reasons they gave for this was that this was insurance against ongoing risks. They did it despite the fact that the economy in the U.S. is growing at a moderate rate. 

There's certainly no sign of recession as yet in the U.S. as they've got strong household spending, which is very supportive of the US economy. There is also a very healthy job market with extremely low unemployment and U.S. incomes on average are still rising.

On the downside  business investment and exports remain weak. There are clear signs that manufacturing output has declined over the past year and the sluggish growth abroad is starting to affect the U.S. The trade war is now also starting to weigh on the U.S. economy.

The European Central Bank has also responded to the weakening of economic data and its response has been to make its negative interest rates even more negative. 

Below the European Central Bank gives the five ways in which it is implementing its very accommodative policy.

The Bank of England has not cut its interest rate, its official bank rate is still 0.75%. 

As financial conditions start to deteriorate, after Brexit they may have to cut interest rates in order to stimulate the economy. However they have said that cutting interest rates after Brexit is not a foregone conclusion

My Portfolio

Market Changes

Next I will examine the market changes my portfolio. 

As illustrated below I have quite a bit of exposure to the United States but also to Europe and to a lesser extent Asia Pacific. Therefore if sterling strengthens that's bad for my portfolio.

Below is the value of sterling versus the U.S. dollar.

After they announced a general election in December 2019 sterling rallied considerably because the probability of a No Deal Brexit fell sharply. That rally has in turn hurt the non-Sterling parts of my portfolio.

Below is what the risk-return plot looks like for Vanguard funds between 2016 and April 2019.

Risk is along the bottom, so high-risk is on the right and low-risk is on the left. Return is on the y-axis, so low returns are bottom and high returns are up top.

The 3 funds I chose in April were:

• Global Minimum Volatility Factor, which is one of Vanguard's global equity funds.
• UK investment Grade Corporate Bonds, because I didn't want to have too much equity risk.
• Emerging Market Government Bonds, because of their very high dividend yield.

If we update that graph below for October 2019 the story is pretty much the same.

Global Minimum Volatility Factor is still performing fairly well compared to other assets.

My safety play, which is UK Investment Grade Corporate Bonds, have done their job, which is to have low volatility and to provide a little bit of income. 

The Emerging Market Government Bonds have held their value and they have provided a very high level of income. 

If we rank those funds available from Vanguard by their 12-month yield you can see that at the top of the table we still have Vanguard US Dollar Denominated Emerging Market Government Bonds with a yield of over 5%.

How I Beat the Market

The way I've chosen to beat the market is to have factor funds. The factor I've chosen to have low volatility. In previous iterations of my portfolio I have included Global Value, but if you want more detail about that then there is a video on YouTube about it.

Vanguard offers four of these factor funds:

• A Global Value Factor Fund - which buy stocks which are cheap according to three valuation measures.
• A Momentum Factor Fund - which buys stocks which are trending upwards in price
• A Liquidity Factor Fund - which buys stocks which have low liquidity. 
• A Global Minimum Volatility Fund (the Fund I include) - which chooses stocks for optimal diversification low risk.

A reason that I like the global minimum volatility fund is that it contains a lot of real estate investment trusts and these offer quite good income over the long term. 

A reason I don't like this fund is that it has a 50% exposure to the U.S. and as we saw earlier, the valuations there are very high at the moment.

Making Changes?

I'm going to finish by looking at the portfolio changes.

 If you are familiar with my videos on YouTube or have read my booklet, which describes how I allocate,  you'll know that I start from risk. 

Part of the way I analyse risk is by using a tree and in this tree I characterise various markets using characters from Scooby Doo.

A tree is a very simple way to visualise the behaviour of asset classes,  just as you could describe the different characters in Scooby Doo in a tree.

What's different about this tree is that it's sideways. It grows from left to right and the illustration below is what the correlation tree looks like using the latest data.

It splits very cleanly into bonds at the top and shares at the bottom. 

Bonds, I've characterised with Velma because they're kind of boring and prudent. 

The shares I've characterised as Scooby Doo, because Scooby's a little bit exciting and a little bit crazy.

Notice how I've chosen one fund from each part of the tree, that way I'm not doubling up my risk.

I've chosen an Emerging Market Government Bonds at the top of the tree.

I've chosen UK investment Grade Bonds in the middle of the tree.

From equities, which are all shown in blue,  I've chosen the Global Minimum Volatility Factor, because I don't want to take too much equity risk.

Now it turns out that my new allocation is the same as my old allocation, so the only question is; Should I re-balance my portfolio?

Should I Re-balance?

There are various optimal ways of choosing a portfolio.

For my three funds I previously used a slightly modified version of a risk parity portfolio. Where the contribution to the risk of my portfolio is the same from every asset class. 

In practice this means you have very little equity in your portfolio because it tends to have a higher risk.

I then took those risk parity weights and adjusted it so that I had 60% bonds in my portfolio and 40% equity.

When I did that I ended up with:

• 20% of the Emerging Market Bonds 
• 40% of the UK investment Grade Bonds 
• 40% in equity,  in the Minimum Volatility Fund

If I rebuild these optimal portfolios using the latest data then the numbers come out exactly the same.

That means for now I'm not going to change my portfolio allocation as there's really no need. My portfolio weights are pretty much where I want them, 60% bonds and 40% equity.

If the markets had moved a lot then I would have re-balanced and I might do that in a future update, but for now there's no need to do anything .

Summary

The macroeconomic data has got slightly worse but the central banks, particularly in the U.S. & Europe, have become more accommodative, which should help counteract those negative effects on the economy.

I will however be keeping  a very close eye on the factors we looked earlier on in the blog.

These are: 

• Nonfarm payrolls 
• Spread in credit markets 
• Volatility in markets
• The PMI indices, which give you a forward-looking idea of what's going to happen to growth in the near future.