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Is the stock market overvalued? Wolfgang Münchau said it is in Monday's FT. He cites some persuasive evidence, based on analysis by smart people like Professor Robert Shiller and Andrew Smithers. The U.S. stock market is overvalued by more than a third, we're told.

Our own work suggests that caution looks increasingly prudent when it comes to risk exposures in asset allocation. But we're not sure. To be precise, we're not sure that a given quantitative profile of the market dispenses timely information about what returns will be in the immediate future. And neither does anyone else.

It's tempting to thinking otherwise, but the future is always unclear. The good news is that the ambiguity oscillates with degrees of vagueness. But that alone isn't enough. The challenge for investing is finding context and structure for managing asset allocation through thick and thin; through times when the future looks reasonably clear as well as during periods when the near term outlook for risk and return is murky.

The good news is that more than half a century of financial economics provides us with the tools and concepts for thinking clearly and productively about designing and managing asset allocation for the long haul, which arrives one day at a time. Different investors will come to different conclusions, but everyone should begin at a common point: the market portfolio.

By market portfolio we're talking of all the major asset classes weighted passively. This boils down to a global mix of stocks, bonds, REITs and commodities. Those four constitute the "major" asset classes in the sense that all are readily available at low cost through ETFs and index mutual funds or, if you're so inclined, actively managed funds. For most investors, these markets (and their various subgroups) constitute the lion's share of the investment choices, and so this is where much of the heavy lifting in the money game takes place.

Weighting all these asset classes by their respective market values gives us a robust benchmark to begin our analysis. Too many investors are convinced that the market decisions in the aggregate tell us nothing; but this is shortsighted. The market portfolio isn't a crystal ball, but neither is it chopped liver. We shouldn't be so naive to think the market portfolio constitutes a short cut to quick success, but neither should we dismiss the collective judgments of all the world's investors.

The first step is recognizing that the market portfolio, flawed though it is, is a valuable resource. Unfortunately, finding a good benchmark that represents all the world's investable assets isn’t easy. Indeed, much of the financial industry pays no attention to this benchmark. No wonder, then, that such a benchmark is generally unavailable, which is why we calculate our own homegrown version. And for good reason. Everyone needs a neutral benchmark as a starting point to consider the choices. We need to know how this benchmark has performed, and how its risk profile has changed over time.

In short, we must study the market portfolio. We're not necessarily going to own it per se, but we need to recognize that in the very long term the market portfolio will deliver average returns and risk relative to the wide variety of money management strategies.

Projecting the long run return for the market portfolio is essential as a building block for designing and managing asset allocation. The truth is that you'll go blind looking for analytics and data on this critical index, but it's hard to overemphasize the power of routinely analyzing this benchmark. At the same time, it's probably the most under-utilized piece of analysis in all of money management. But if we have any hope of gaining strategic insight in the all-important business of asset allocation, we need to have a broad benchmark of the market portfolio and become intimate with its risk and return profile.

It's important to point out that finance theory advises against trying to forecast equilibrium returns directly. A more reliable approach is calculating implied returns by looking at volatility and correlations between the asset classes. In effect, we're reverse engineering the market's prospective return by studying its risk parameters, which offer more reliable insights compared with studying returns directly.

With expected equilibrium returns in hand, the real work begins. At this point, we can start to integrate our views about individual asset classes and whether they're likely to generate higher or lower returns relative to their long run equilibrium performance estimates. If we're fairly confident in our forecast, we'll change the weight of the asset class in our model portfolios up or down, depending on the forecast, relative to the market portfolio weight. But the pesky problem of always have doubts about the future keeps us from straying too far from the market portfolio's asset allocation.

For some investors who are highly confident in their outlook, the resulting portfolio will look radically different from the market portfolio. At the other extreme is an investor who has no particular view, which implies holding the market portfolio as offered.

The real benefit of analyzing portfolio choices in this way is that it provides valuable context and perspective for understanding our particular worldview. Simply going through the process of estimating equilibrium returns, and reflecting on what that implies for the market portfolio and individual asset classes, is an education of immense power.

Alas, too much of what passes as investment advice starts at the opposite end of the spectrum. It's tempting to dive into the debate about whether the stock market, or any other market, is overvalued or undervalued. But that courts disaster if the analysis lacks broader context for assessing risk and thinking about asset allocation.

There are no short cuts in designing and managing a portfolio strategy that satisfies in the long run. Fortunately, there's a productive starting point. The bad news is that too few investors are paying attention.

Source: The Market Portfolio as an Investing First Step