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When past returns have been high, future returns are more likely to be low. But
people don't realise that
THE award of the Nobel economics prize to Richard Thaler is a reminder that
economics has been struggling, in the past 30 years, to adapt its models to the
real-life decision-making processes of actual humans. The problem applies as
much in investment as anywhere else.
One of the biggest problems is the tendency to assume that the future will
resemble the past. Despite all the warnings inserted by regulators, investors
often believe that fund management performance will persist, but the evidence
is against it. Another issue is the assumption that overall market returns will
persist.
This may be one of the factors explaining the big deficits at state and local
pension funds in America. Those funds are allowed to make their own
calculations at the expected rate of return on their assets; the higher the
assumption the less taxpayers and employees are required to stump up.
From where do they get their numbers, which tend to be in range of 7-8% return?
It is hard to believe they haven t been affected by past returns, which were
7.8% over 25 years and 8.3% over 30 years. The median assumption has edged down
from 7.91% in 2010 to 7.52%, according to a report from the National
Association of State Retirement Administrators. Since the turn of the
millennium, it has probably fallen around half a point. But there is a big
difference in valuations between now and then; at the start of 2001, the
10-year Treasury bond yielded 5.2%. It now yields 2.4%
Why does this matter? The return from bonds is clearly the starting yield plus
or minus any changes in valuation and minus any losses from default. When bonds
move from a higher yield to a lower yield, there is a rise in price which gives
investors an excess return. To believe that this return is repeatable, you must
assume that yields will fall even further and that gets increasingly less
likely as yields approach zero.
Let us say for the sake of argument that a pension fund has a portfolio split
of 70% equities and 30% bonds; assume also that with the help of corporate
debt, the fund can earn an extra percentage point on its bond portfolio. At the
start of 2001, then, a pension fund could expect 6.2% on its 30% bond
allocation; or 1.86%. That required it to earn 8.8% on its equity portfolio in
order to reach an 8% target. The equity risk premium required was 8.8% minus
5.2%, or 3.6 percentage points, slightly below the historic average. But run
those numbers now and you get 1.02% from your bonds (30% of 3.4%) requiring a
9.25% return on equities to get to 7.5%. That equates to an equity risk premium
of seven percentage points, way higher than history.
Is that in any way justified? As our briefing in last week s issue pointed out,
valuations are pretty high across the board. American equities are on a
cyclically-adjusted price-earnings ratio of 31, according to the website of
Robert Shiller, a previous Nobel winner. In the past, high valuations have been
associated with low future returns.
So it could be argued that high market valuations are quite rational, if
investors believe future returns will be low. But the numbers from the pension
fund industry suggest that is not the case at all; cognitive dissonance is
going on (a well-known behavioural trait).
The low rate conundrum
Another approach is to say that high valuations are justified by low interest
rates. An equity is worth a stream of future cashflows, discounted to the
present day; as long-term yields fall, so does the discount rate, and the
present value of an equity rises.
But that only deals with one part of the equation, as a paper from strategist
John Hussman argues.
If interest rates are low because growth rates are also low, no valuation
premium on stocks is justified by the low interest rates. Prospective returns
are reduced without the need for any valuation premium at all.
In other words, if the discount rate falls because of slow growth, so should
your expectation of future cashflows (profits). And future growth is likely to
be slow given the demographics (a flat-or-falling population of working age in
many western countries) and very poor productivity growth (Estimates for
Britain have just been revised lower).
What has kept profits high, as Mr Hussman remarks, is the shift in power
between capital and labour in the wake of the financial crisis; a shift that
has depressed wages and fuelled the rise of populism. This can t continue, he
adds:
There s no way to make the arithmetic work without assuming an implausible and
sustained surge to historically normal economic growth rates, a near-permanent
suppression of interest rates despite a full resumption of normal economic
growth, and the permanent maintenance of near-record profit margins via
permanently depressed real wage growth, despite an unemployment rate that now
stands at just 4.2%.
Again, investors seem to assume that past conditions will simply persist,
despite the evidence. This behavioural bias will prove their undoing.