It’s Only Like This, Until It’s Like That
This morning I received a blog written by Brad DeLong which asked a simple question; why are people depressed about medium-term prospects for equity investments? He claims he doesn’t understand the gloomy mindset. However, the evidence contradicts DeLong’s underlying assumption about investor attitudes. And when we dig deeper, we find that history doesn’t support his assumption about future market returns.
The title of his post suggests that MANY individuals are depressed about future equity returns which would suggest that investors are bearish and are hoarding cash. However, this is hardly the case when the majority of investors are fully invested and leveraged as shown in the two charts below.
There are only a few people, besides myself, that discuss the probabilities of lower returns over the next decade. Henry Blodget, the focus of the DeLong’s post, Jeremy Grantham, Doug Short, Crestmont Research and John Hussman are the most notable.
Let’s jump into Brad’s math. He states:
“I see that stocks are likely to return:
- 6%/year in real (inflation adjusted) terms,
- plus or minus whatever changes we see in valuation ratios.
That means that if we expect to see P/E10 fall over the next decade from 25X to 19X then we can expect to see returns of 3%/year real–that is, 5%/year nominal. That means that if we expect to see P/E10 fall all the way back to 15X over the next decade, then we can expect to see returns of 1%/year real–that is 3%/year nominal. But that is unlikely to happen. And if P/E10 remains at its current valuation ratios, we have 6%/year real returns–8%/year nominal.
Equities still look very attractive to me…”
First, he makes the assumption that stocks will compound at 6% per year, every year, going forward. This is a common mistake that is made in return analysis. Equities do not compound at a stagnant rate of growth but rather experience a rather high degree of volatility over time.
The chart below shows the S&P 500 as compared to annualized returns and the average of market returns since 1900. Over the last 113 years, the market has NEVER had a 6% return. The two closest years were 6.94% in 1993 and 5.24% in 2005. If we give it a range of 5-7%, it brings the number of occurrences to a whopping three.
Assuming that markets have a set return each year, as you could expect from a bond, is grossly flawed. While there are many years that far exceeded the average of 6%, there are also many that haven’t. But then again, this is why 6% is the “average” and NOT the“rule.”
Secondly, and more importantly, the math on forward return expectations, given current valuation levels, does not hold up. Brad assumes that valuations can fall without the price of the markets being negatively impacted. History suggests, as shown in the next chart, that valuations do not fall without investment returns being negatively impacted to a large degree.
Furthermore, John Hussman recently did the “math” in this regard showing this to be true.
“Let’s assume that despite the weak economic growth at present, nominal GDP picks back up to a nominal growth rate of 6.3% annually from here. This may be overly optimistic, but near market peaks, optimistic assumptions often still result in troubling conclusions. Given the present market cap / GDP ratio of 1.25 and an S&P 500 dividend yield of just 2%, what might we estimate for total returns over the coming decade?
(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually.
Since we use a whole range of additional measures, including earnings-based methods, to estimate prospective returns, our actual estimates are somewhat higher here, at about 2.4% annually over the coming decade. Tomato. Tom-ah-to. Keep in mind that these estimates assume a significant acceleration in economic growth. One can certainly quibble that the long-term ratio of market capitalization to GDP will have a somewhat higher norm in the future. But the present ratio is still 100% above its pre-bubble norm. It’s unlikely that this situation will end well.
The chart below shows the record of these estimates since 1949, along with the actual 10-year S&P 500 total returns that have followed.”
As the Buddha taught, “This is like this, because that is like that.” Extraordinary long-term market returns come from somewhere. They originate in conditions of undervaluation, as in 1950 and 1982. Dismal long-term returns also come from somewhere – they originate in conditions of severe overvaluation. Today, as in 2000, and as in 2007, we are at a point where “this” is like this. So “that” can be expected to be like that.”
Nominal GDP growth is likely to be far weaker over the next decade. This will be due to the structural change in employment, rising productivity which suppresses real wage growth, still overly leveraged household balance sheets which reduces consumptive capabilities and the current demographic trends.
Therefore, if we assume a 4% nominal economic growth, the forward returns get much worse at -5.2%.
Brad is an extremely smart economist. However, the analysis makes some sweeping assumptions that are unlikely to play out in the future. The market is extremely volatile which exacerbates the behavioral impact on forward returns to investors. (This is something that is always “forgotten” in most mainstream analysis.) When large market declines occur within a given cycle, and they always do, investors panic sell at the bottom.
The most recent Dalbar Study of investor behavior shows this to be the case. Since the inception of the study (1984), the S&P 500 has had an average return of 11.11% while equity fund investors had a return of just 3.69%. This has much to do with the simple fact that investors chase returns, buy high, sell low and chase ethereal benchmarks. (Read“Why You Can’t Beat The Index”) The reason that individuals are plagued by these emotional behaviors, such as “buy high and sell low,” is due to well-meaning articles espousing stock ownership at cyclical valuation peaks.
As I stated previously, the current cyclical bull market is not likely over as of yet. Momentum driven markets are hard to kill in the latter stages particularly as exuberance builds. However, they do eventually end. That is unless Brad has figured out a way to repeal economic and business cycles altogether. As we enter into the sixth year of economic expansion we are likely closer to the next contraction than not. This is particularly the case as the Federal Reserve continues to extract its financial supports in the face of weak economic underpinnings.
Will the market likely be higher a decade from now? A case can certainly be made in that regard. However, if interest rates or inflation rises sharply, the economy cycles through normal recessionary cycles, or if Jack Bogle is right – then things could be much more disappointing. As Seth Klarman from Baupost Capital recently stated:
“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”
We saw much of the same analysis as Brad’s at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same. It is likely that this time is “not different” and while it may seem for a while that Brad analysis is correct, it is “only like this, until it is like that.”
You can access the original blogpost here