January 24, 2013
By Steve Blumenthal
We frequently hear that the economy is bad so stocks are down or the economy is good so stocks are up. I’m sure you cringe along with me when you hear the news reports incorrectly justifying that day’s market move.
I believe that the best predictors of forward returns are starting valuations, dividend yields and implied inflation. Recently, I featured a chart from Research Affiliates projecting the lowest 10 year expected 60/40 investment return in the last 14 decades. Low dividend yields, low implied inflation and low interest rates are the culprits. This projects a return of less than 4.5% as compared to the historic average of 7.5%. Not great odds for underfunded pensions targeting 8% or for individual investors thinking their 60/40 portfolio will earn them 8-10% or more.
In today’s On My Radar, I provide a link to Jeremy Grantham’s February 2013 letter titled “Investing in a Low-Growth World“. Jeremy, along with El-Erian, Gross, Reinhart-Rogoff, Arnott, and others that I respect (and with considerable skin in the game), anticipate a low GDP growth environment for some time to come. Estimates range from 1% to 2% (considerably below the historical and deeply modeled and hoped for 3% average). Note: GDP over the last ten years grew at just 1.9%. Grantham’s best guess is 1.5% growth.
I share this with an eye towards the confusion your clients must feel (ours certainly do) when they try to link the economy to the market. There have certainly been periods of above 3% GDP growth and poor market returns and periods of good market returns. Frankly, the historical correlations to economic growth and market return are not so correlated. Our collective job is to shape portfolios to drive returns that meet goals and, importantly, help shape proper client expectations.
My two cents is that if your starting point is at a point of high valuation (like today’s Shiller PE of 22.3), then it is difficult to expand profits in such a way that can expand the PE ratio farther from the norm (thus limiting price gain). Good growth won’t impact price performance as much and low growth can certainly hurt PE expansion; especially if cost inputs are rising (inflation).
Given the current high valuations, low dividend yields and a potential for significant inflation, a forward expected return of 5-6% for equities and 2% for fixed income (the yield on the 10-year Treasury) looks probable to me. This is whether GDP growth is 3% or 1.5% (though it is better to have 3%).
What if there is a shift in thinking? I see a generational buying opportunity ahead; one at attractive valuations, higher dividend yields, higher interest rates and higher inflation. The current period favors a disciplined focus on risk management to enable your client to be properly positioned for the outstanding opportunity ahead.
The problem is that without proper risk management structure today, they will likely again panic sell out at the next cyclical bear low. Convincing them that the opportunity is happening now will be challenging to say the least. Thus, get them forward thinking and prepared today. It won’t feel like a generational opportunity when the opportunity arrives.
Jeremy always gets my mind moving. Put on your quant goober hat as Jeremy gets technical but I believe it is well worth the read. Here’s an excerpt – the link follows below.
Engineered Low Interest Rates
The Fed’s negative real rates regime, designed to badger us into riskier investments in order to push up equity prices and grab a short-term wealth effect (that must be given back one day when least comfortable and least expected), has gone on for a long and, for me, boring time. This low interest rate period is serving, therefore, as a sneak preview of what a permanently lower rate regime might look like (although any permanently lower rates reflecting lower GDP growth would be by no means as low as these engineered rates that we are currently experiencing). So what are some of these effects? The artificially low T-Bill rates first work their way slowly up the curve. Next, the most obviously competitive type of equities – high yield stocks – begin to be bid up ahead of the rest of the market, as has happened. “I’ve just got to squeeze out some higher rates somewhere, anywhere,” is the pension fund plea.
Then, this low rate competition begins to filter into other securities, historically sought after for their higher yields: higher-grade real estate, where the “cap rates” slowly fall; and, unfortunately, also forestry and farmland, mainly of the larger and more standard varieties that appeal to institutions, which show declines in their required yields, i.e., their prices rise. The longer the engineered rates stay below true market rates, the higher asset prices become until, yes, you’ve got it, corporate assets begin to sell way over replacement cost.
Then, if the heart of capitalism is still beating at all, a long period of over-investment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good healthy market crunch. (This strategy will be seen in future years as archetypical of the Greenspan-Bernanke era: badger and bully investors into taking more risk and eventually pushing assets – houses or stocks or both – far over replacement value, followed eventually, at long and hard-to- predict intervals, by exciting crashes. No way to run a ship, but it does produce an environment that contrarians like us, who can take a few licks, can thrive in.)
Click here to view the full piece.
I was up at 4:30 am this morning and the house was buzzing by 5:00 am. Five kids up (Susan’s three boys, and my two) and two cars packed (skis, helmets, jackets and stuff). Destination – Snowbird, Utah.
I’m writing you from 35,000 feet. This is my 33rd year in a row at Snowbird. To say the mountains are part of me is an understatement. My kids share this love and this is year two for Susan and her boys. I hope they find the same love.
As I look around, I see computers turned on and my gang of five with head phones on beating to the steady thump of rap music. Susan and I are excited, happy and grateful. At least one of us is praying for some very deep, fresh, new snow!
Wishing you the very best!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
steve@cmgwealth.com
610-989-9090 Phone
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