Investors who have been reading my analyses post 2008, or attended my speeches and presentations across the country, know that "the outlook for investment returns" -or call it "The New Normal"- has been one of my central themes ever since the Bull Market of 2004-2007 came to an abrupt, and painful, end.
Whereas many a commentator kept on referrring to pre-2007 data as evidence that local equities were looking cheap, I instead have continued to argue the period 1981-2007 has been a rare exception in modern history and therefore it cannot possibly be an accurate reference for investors today (or tomorrow).
What does this tell us about future investment returns?
My view has been that the exceptionally buoyant returns between 1981-2000 and between 2004-2007 were likely to be followed by sub-par returns from equities in the following years.
From an Australian perspective, this view has proven accurate. My emphasis on "All Weather-Performers"(*) and on "reliable, growing dividends" in the post-2008 years has been a winning strategy. At the same time, my dislike for energy, miners and other riskier propositions has certainly kept the big losers at bay (at least for those investors who paid attention and stuck to the strategy).
The story has been pretty similar for equity markets in Europe and throughout Asia, but not so in the US where indices (including dividends) are now back at 2007 levels. Just goes to show: there's always room for exceptions. By the way, applying my emphasis on "All-Weather Performers" and on "dividends" would still have been a winning strategy in the US.
Needless to say, the performance of US equities has surprised many an expert, including myself. The performance gap between US equities and (most of) the rest of the world has by now created a different mindset among local experts. In the US, research reports talk about "bull market", with rosy outlooks being published for the coming five years. In China, the main question being asked by investors is how much longer and how much deeper can the local bear market go on for? The Shanghai Composite index is now trading at levels not seen since 2009. Somewhere in the middle sits Australia.
So what should investors expect for the years ahead?
The discussion about future investment returns received a fresh injection of stimulus on the final day of July when global bond expert, founder and MD of Pimco, William H Gross released his latest Investment Insights. Under the title "Cult Figures", Gross dared to take a swipe at what he thinks is a misguided "rule of thumb" among equity experts that higher risk equities will over time, and no matter what the circumstances, generate inflation adjusted average annual returns of 6.6% per annum. Gross's bottom line: ain't gonna happen.
Investors better not set themselves up for major disappointment.
As one would have expected, Gross's public attack on the "dying equities cult" has led to strong rebuttals, criticisms, rejections and counter-attacks from equity experts across the globe. The anti-Wall Street, more hippy-like guru of the "New Normal" world has a loyal following across all age groups on all continents, but in circles where equities are the main meal for the day, it would appear people do not like him. They like him even less after his Investment Insights for August.
Let's pause and take a closer look at the main points of criticism that have erupted over the past three weeks:
- GDP growth is not a good indicator for equity performance
- Equity performance is not only about share price appreciation, it includes dividends too
- Equities are not dead, government bonds are
Most of the criticism that has erupted relates to point number one, with Morgan Stanley's resident Australian bear-strategist Gerard Minack chipping in with a dedicated report last week on how time and time again it can be proven there's virtually no correlation between a country's GDP growth and the performance of its equity market. I suspect this won't surprise too many among you as this theme has been one of my personally favourite "myths to debunk" in years past. As far as my personal analysis goes, the only times when a close correlation comes into play is when GDP growth is about to turn negative or when it is close to reversing from negative to positive.
An easy example to refer to is "have you looked at the Chinese share market lately?" While every economist continues to express the view that China's growth remains the envy of the rest of the world, investors in Chinese equities have had an absolute horror experience, and that is putting it nicely. Another easy reference is, of course, Australia. Living in the world's strongest Developed Economy has lured a lot of investors into the wrong ideas post 2008. There is, clearly, also a large gap between the economic performance of the US and its equity markets.
Point made and point taken. I guess the positive take-away from all this is that I can now add that my personal analysis has the support from the creme de le creme among the world's equity specialists.
(All this leaves unanswered as to why "the market" gets so hyped up over individual economic data and indicators, but that's a discussion for another time.)
It would appear that Gross's reasoning as to why returns from equities cannot sustainably outperform dismal GDP growth in the longer run is based upon one very big misconception: that equity returns are predominantly made through appreciating share prices while, instead, dividends become ever so important over longer term horizons. Mind you, not that Gross would be the first to make this error it does give his detractors a stick to poke and hit with, and they have en masse grabbed the opportunity. Pinata time!
Dividends do not automatically stay in the share market. Part of it is spent and consumed and thus dividends provide a positive loop from the share market into the real economy via consumption into wages and company profits and back into share prices and dividends.
What I personally find missing in both Gross's analysis as well in the many critiques is that US profits are not solely made in the domestic economy, which arguably seems to be stuck in low, uninspiring growth dynamics.
Is a new world dynamic whereby developing economies keep profit margins high for multinational, US-based companies a feasible and sustainable alternative? Or what about the predicted shift towards cheap energy on the back of the US's shale gas and oil "revolution"? Is cheap energy going to compensate (plus some) for more expensive labour in the decade ahead?
At least Gross is trying to tackle the issue that the Greatest Bull Market in Modern History (1981-2007) was partially possible because of a shift towards more emphasis on "capital" in the US economy, whereby the government gave up some of its own share in GDP and "labour" was made ever so cheaper. The chart below, which is taken from "Cult Figures", speaks a thousand words on its own.
The real question then becomes: since it would appear that US corporates have become ever so richer, while the average US worker became poorer and poorer how long can this symbiosis continue?
(Incidentally, maverick documentary maker Michael Moore's "Capitalism: A Love Story" asks the same question. It was aired on Australian television over the weekend).
The discussion about whether equities will now outperform government bonds in the decade ahead is a rather futile one. Even Gross states in his Investment Insights that the outlook for returns from low yielding government bonds is unattractive now that bonds have significantly outperformed equities over the past thirty years. Earlier this year Goldman Sachs talked about a once-in-a-generation opportunity.
I have been expressing exactly that same view since last year. Everyone looking to invest today should shun government bonds, even in Australia. Everybody who owns government bonds should reconsider as large losses can loom from relatively small adjustments. If we are on the cusp of a more pronounced "correction" then immediate action to preserve investment capital has become an absolute necessity. Don't buy the balanced portfolio idea!
From my perspective, the most important points in Gross's "Cult Figures" are made towards the end, when he suggests that, assuming the prediction for lower than past returns is correct, financial service providers, society as a whole and governments in particular will gradually start adapting to the "New Normal" as this will inevitably lead to a poorer living standard in Developed Economies. It is Gross's view the response from governments will be to artificially inflate those returns back to previous levels, even if this only creates the illusion that "wealth" is still among us.
Now THAT is a pretty scary outlook, if ever we contemplated one.
Gross's conclusion that "The cult of equity may be dying, but the cult of inflation may only have just begun" should be firmly on every investor's radar.
In the short term, it would appear both investors and experts are increasingly warming towards the idea that a repeat of the 2009 experience, when equity markets rallied hard for about six months, will soon be upon us. There are more than just a few similarities in today's market: low confidence, low volumes, low priced risk and... US bond yields are exactly at that same, low point. Are we waiting for another gun shot from central bankers?
(The chart above has been dubbed "the most important chart in the world" by BA-Merrill Lynch. It feeds the idea that 2009 might be repeating itself in 2012.)
Despite the fact that short term buoyancy always brings out knee-jerk proclamations of a new bull market, investors are being reminded of that very same 2009 experience and here we are, three years later, and Gross's questions remain ever so pertinent. At least, if we omit the big exception that have been US equities.
By Rudi Filapek-Vandyck
(This story was originally written on Monday, 20th August 2012. It was published in the form of an email to paying subscribers on that day)
(*) I have written multiple times about "All-Weather Performers" in the past. Paying subscribers receive two e-booklets of which the second, "The Big De-Rating. A Guide Through The Minefields" explains the concept in more detail.P.S. Investors who want to read the original story published on Pimco's website can do so here, while they can find some of the critiques that have been released in response here.