Timing and valuation risk

  • The models are exposed to timing and relative valuation risks, which are different from many conventional value-based approaches.
  • We use excess volatility as one of the inputs into the process. This makes equities look “expensive” after a period of high volatility, which is often associated with falling returns.
  • On these occasions equities may look “cheap” on a conventional valuation basis.
  •  Many investors find it counter-intuitive, or just plain wrong, to avoid equities when they offer a high dividend yield or low PE ratio and then start buying only after they have started to rise.
  • The point they often miss, is that while equities have been getting “cheaper”, bonds have probably been getting “more expensive” – i.e. producing positive returns with relatively low risk.
  • There is of course no guarantee that equities or any other risk asset will continue to perform well once the model has rebuilt its exposure to those assets.