Trying to determine investment strategy hinges on a seemingly impossible exercize. Namely, predicting what the world will be like. The most important metrics are interest rates and real rates of return for the more critical asset class alternatives. Despite our having invented over the past couple of decades a plethora of new security types (derivatives, art, many varieties of real estate and international categories), planning ahead still hinges on the real rates of return for bonds and equities. Since the real rate of return takes inflation into account, we need to have some idea what this figure might be.
Governments, pension plans and financial institutions of all sorts require a very long term perspective. Of course, a shorter-term game plan is vital to remain solvent over the longer-term, but like a football team the objective of individual (ST) plays is to win the (LT) game. Examining footage from older games is not an uncommon place to begin.
The challenge for us is that the 20th Century was riddled with volatility. Just consider the yields since the 1920’s on longterm U.S. Treasury bonds.
Portfolio managers like me weren’t born until WW2 was over, and hordes of investment professionals working today can’t imagine a world with mortgage rates north of 16%. Wild a ride as it’s been, some rules of thumb learned by years of excruciating experience seem to work. Art Yeates, an extremely insightful bond manager and friend once told me the best expected return (nominal) for a bond is its yield. If you’re a curious sort (like me) then you might notice that back in 2000 when the yield on ten year Treasuries was somewhere around 6%. Oddly enough, the total annual return from a portfolio of long bonds from 2000 to 2010 was about 5 1/2%.
Over the years I’ve argued that institutional investors aren’t very good at asset allocation decisions. Since long Treasuries are now yielding 1.64% does it make sense (best expected longer-term rate of return is the current yield) to overweight bonds? The following is from an article aptly entitled Bonds Switch Signals End of Cult of Equity: (cnbc.com)
The trend is not limited to the UK. In the US, Europe and Asia, some of the biggest pension funds and asset allocators have been switching into fixed income. For example, Allianz, the world’s second biggest manager of money with about 1.7 trillion euros under management, has only 6 percent of its insurance portfolio in equities while 91 percent are in bonds. A decade ago, 20 percent was in equities.
A pension trustee at a big UK fund says: “We have been switching into fixed income for the past 10 years because of a number of reasons. Since 2002, there have been two stock market crashes, which have shaken equities and makes it difficult for funds like ourselves to deal with the volatility.
You probably already noticed that Allianz should have had 91% in bonds TEN YEARS AGO but didn’t. Hindsight is perfect mind you, but this confirms my judgement that the current mix in favor of bonds by institutional investors can only be wrong yet again.
A useful (because we’ve nothing else) starting point is to consider average returns over the course of the volatile 20th Century. I borrowed this chart from a study I stumbled across: Risk and Return in the 20th and 21st Centuries by Elroy Dimson, Paul Marsh and Mike Staunton, Business Strategy Review, 2000, Volume 11 Issue 2:
For want of a better idea, let’s say inflation will continue at 2% (and that the deflation experienced in 2009 was an anomoly, likely to occur once in awhile over 100 year periods) and long bond holders will require a real return of 1.5%. This puts nominal rates in the neighborhood of 2% + 1.5% = 3.5% or higher depending upon the quality of the bonds. This implies that current (negative real return) Treasury yields will average a higher rate than they’re at now (surprise?) over the 21st Century. This is not a good omen for bondholders today.
Keeping it simple, a real return of 5.5% for equities, with 2% inflation suggests a longterm nominal return from stocks of 7.5%.
I did say we needed a starting point. In practical terms, it makes sense to believe we’ll see more of what we experienced over the past 100 years in real terms. The problem is that inflation will fluctuate by country (as it always does), unexpected growth in selected economies will create unanticipated higher real returns in those stock markets, and the premiums demanded by investors will change based on their tolerance of volatility.
Right now, investors won’t pay for volatility at all regardless of the potential return. In fact they will accept a negative real rate of return in order to avoid volatility. The economist in me says this is irrational. A behavioral scientist might offer up some explanations – excessive (and negatively skewed at that) volatility in recent times might bias our thinking for example.
In past commentaries, I’ve suggested the S&P 500 has ‘priced in’ a nominal 6% (4% real) return assuming no earnings growth. In order to earn better than this in the future; revenues, earnings and cashflow will have to grow. Is the world economy moving in a direction that will facilitate growth?
There has never been more data, equations, quantitative analysts and math wizards, but these help only to provide context – we still have to make judgements about the future. I believe in the KISS principle. All I can determine going into 2013 is that bonds are priced as if there is no risk, and that stocks are priced as if no amount of growth will justify the volatility. You can probably figure out what this implies in terms of asset allocation.
What will the next hundred years look like? On average it will look like the last 100 years.