Robust Errors

June 15, 2023

“For the robust, an error is information,” Nassim Nicholas Taleb

The Vanguard Capital Markets Model® currently projects S&P 500 annualized returns of 5% over the next decade. This compares poorly with the historical 10% average annual return for the index. To make matters worse, expected volatility is still unchanged at 17%. While risk is projected to be the same for investors, returns are expected to be half as good.

Why does Vanguard expect returns between 2023 and 2033 to be worse than average? Because valuations are elevated. Any measure you scrutinize that has demonstrated predictive power is currently priced materially higher than average: price-to-sales; market cap-to-GDP; Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE); etc.

But does this information about the future help us in the short term?

“Valuations… are not predictive over the shorter term. Yes, over the long run valuations are predictive of performance. But you can have extended valuations for an extended period of time. And the reality is that the biggest issue most investors face is not participating in the equity market,” Kristina Hooper, Invesco, Chief Global Strategist on Blomberg Surveillance 1/20/20

Conventional Wall Street wisdom, we’ll let you be the judge of what that is worth, says that long-term forecasts tell you nothing about the short term. At MKAM ETF we see things differently.

How can we have useful models that forecast performance a decade from now, but tell you nothing about the short or intermediate term? After all, to get to 2032, you travel through 2024, 2025, 2026, etc. We believe that the journey you have already partially completed informs the rest of the trip.

Consider that five years ago, Shiller’s CAPE was 31.2. This is higher than the CAPE that has warranted the historical average of 10% per year annualized returns the S&P 500 has averaged over time. Further, it was above the 26.1 average in the post Greenspan era, from 1988 through today. It would be reasonable to expect the next decade of returns to be lackluster for investors who paid a premium to own stocks on May 31, 2018.

Source: Robert Shiller

Contrary to expectations, the S&P 500 has generated 11% per year returns since then, even higher than the historical average. In fact, in just five years, the S&P 500 has already earned all the returns the CAPE model forecasted over the next decade, given its starting valuation. The next five years must generate negative returns for the prediction of five years ago to prove accurate. To us, the error of the previous forecast is not wrong, it is useful information.

A similar analysis of CAPE predictions of 7, 8, and 9 years ago leads you to the same conclusion. The S&P 500 has already pulled forward future returns into what is now the past. In a world where investors can get 5% returns on their cash, it seems prudent for risk-conscious investors to reduce their exposure to the S&P 500.

MKAM ETF remains 50% exposed to the stock market and 50% in short-term US Treasury Bills earning 5%. The allocation to the stock market comes from our trend discipline only. While the stock market remains in a bullish mood, we continue to participate partway in the gains. However, heeding accurate model forecasts that are only part way towards completing their full cycles has us watching the exit with one eye. For investors that seek to avoid large drawdowns, we suggest taking the right lessons from the best valuation models at our disposal. Better to learn from one error, than to make

Keep Me Informed

Please enter your email address to be notified of new content, including market commentary and special updates.

Thank you for your interest in the MKAM Funds.

100% Spam-free. No list sharing. No solicitations. Opt-out anytime with one click.

Important Information

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. This and other important information is contained in the prospectus, which may be obtained by following the links Prospectus and Summary Prospectus or by calling +1.202.331.3400. Please read the prospectus carefully before investing. Investments involve risk. Principal loss is possible. The Fund is actively-managed and is subject to the risk that the strategy may not produce the intended results. The Fund is new and has a limited operating history to evaluate. Listed below are the principal risks associated with investing in the fund. For a full listing of associated risks, please consult the prospectus. Derivatives Risk. A derivative is any financial instrument whose value is based on, and determined by, another asset, rate or index (e.g., stock options). Unfavorable changes in the value of the reference asset, rate or index may cause sudden losses. Counterparty Risk. Counterparty risk is the risk that a counterparty to a financial instrument held by the Fund or by a special purpose or structured vehicle invested in by the Fund may become insolvent or otherwise fail to perform its obligations, and the Fund may obtain no or limited recovery of its investment, and any recovery may be significantly delayed. Exchange listed options, including FLEX Options, are issued and guaranteed for settlement by the Options Clearing Corporation (“OCC”). The Fund’s investments are at risk that the OCC will be unable or unwilling to perform its obligations under the option contract terms. In the unlikely event that the OCC becomes insolvent or is otherwise unable to meet its settlement obligations, the Fund could suffer significant losses. Leverage Risk. Leverage risk refers to the potential for increased volatility and losses in a portfolio due to the use of derivatives or other financial instruments that may magnify gains and losses beyond the initial investment. The Fund will utilize derivatives, such as options, to gain exposure to certain assets or markets with a smaller initial investment. New Fund Risk. The Fund is a recently organized investment company with no operating history. As a result, prospective investors have no track record or history on which to base their investment decision. There can be no assurance that the Fund will grow to or maintain an economically viable size.

Foreign Investment Risk. Returns on investments in foreign securities could be more volatile than, or trail the returns on U.S. securities. Investments in or exposures to foreign securities are subject to special risks, including risks associated with foreign securities generally, including differences in information available about issuers of securities and investor protection standards applicable in other jurisdictions; capital controls risks, including the risk of a foreign jurisdiction imposing restrictions on the ability to repatriate or transfer currency or other assets; currency risks; political, diplomatic and economic risks; regulatory risks; and foreign market and trading risks, including the costs of trading and risks of settlement in foreign jurisdictions.

Emerging Markets Risk. Many emerging market countries have a history of, and continue to experience serious, and potentially continuing, economic and political problems. Stock markets in many emerging market countries are relatively small, expensive to trade in and generally have higher risks than those in developed markets. Securities in emerging markets also may be less liquid than those in developed markets and foreigners are often limited in their ability to invest in, and withdraw assets from, these markets. Additional restrictions may be imposed under other conditions.

Depositary Receipts Risk. The risks of investment in depositary receipts are substantially similar to the risks of investing directly in foreign securities. In addition, depositary receipts may not track the price of or may be less liquid than their underlying foreign securities, and the value of depositary receipts may change materially at times when the U.S. markets are not open for trading.

Gender Diversity Risk. The returns on a portfolio of securities that excludes companies that are not gender diverse may underperform the returns on a portfolio of securities that includes companies that are not gender diverse. Investing only in a portfolio of securities that are gender diverse may affect the Fund’s exposure to certain types of investments and may adversely impact the Fund’s performance depending on whether such investments are in or out of favor in the market.

Non-Diversification Risk. Because the Fund is non-diversified, it may be more sensitive to economic, business, political or other changes affecting individual issuers or investments than a diversified fund, which may result in greater fluctuation in the value of the Shares and greater risk of loss.

ETFs may trade at a premium or discount to their net asset value. ETF shares may only be redeemed at NAV by authorized participants in large creation units. There can be no guarantee that an active trading market for shares will exist. The trading of shares may incur brokerage. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. We make no representation or warranty as to the accuracy or completeness of the information contained herein including third-party data sources. The views expressed are as of the publication date and subject to change at any time. No part of this material may be reproduced in any form, or referred to in any other publication without express written permission. References to other funds should not to be interpreted as an offer or recommendation of these securities. The Fund is distributed by Quasar Distributors, LLC. The fund’s investment advisor is Empowered Funds, LLC, which is doing business as ETF Architect.