The award of the Nobel Prize in economics to Richard Thaler is a reminder that economics has struggled, in the past 30 years, to adapt its models to the decision-making processes of real people. The problem applies to investing as much as anywhere else.
One of the biggest problems is to assume that the future will be like the past. Despite all the warnings sent by regulators, investors often believe that fund management performance will continue, but the evidence is against it. Another issue is who believes that overall market returns will continue.
This may be one of the factors that explains the large deficits of state and local pension funds in America. These funds are allowed to make their own calculations of the expected rate of return on their assets; the higher the assumption the less tax payers and workers have to give up.
Where do they get their numbers from, which tend to be in the 7-8% return range? It is hard to believe that they were not affected by the past results, which were 7.8% over 25 years and 8.3% over 30 years. The median opinion has decreased 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 by about half a point. But there is a big difference in valuations between now and then; at the beginning of 2001, the 10-year Treasury bond yielded 5.2%. It now yields 2.4%
Why does this matter? It is clear that the yield from bonds is the initial yield and or without any changes in valuation and without any loss of origin. When a bond moves from a higher yield to a lower yield, there is an increase in price that gives investors a higher yield. To believe that this result is possible again, you have to assume that yields will fall even further and that is becoming more and more likely as yields are close to zero.
Let’s say for argument’s sake that a pension fund has a portfolio split of 70% equities and 30% bonds; also assume that with the help of corporate debt, the fund can earn an additional percentage point on its bond portfolio. At the beginning of 2001, therefore, pension funds could expect 6.2% allocated bonds of 30%; or 1.86%. That required him to earn 8.8% on his equity portfolio to reach the 8% target. The required equity risk premium was 8.8% minus 5.2%, or 3.6 percentage points, slightly below the historical average. But run those numbers now and you get 1.02% from your bonds (30% of 3.4%) which requires a 9.25% return on dividends to get to 7.5%. That equates to an equity risk premium of seven percentage points, far higher than history.
Is that justified in any way? As our briefing in last week’s issue said, valuations are generally very high. American equities have a cyclically adjusted price-earnings ratio of 31, according to former Nobel laureate Robert Shiller’s website. In the past, high valuations have been associated with low future returns.
Therefore it could be argued that high market valuations are quite reasonable, if investors believe that future returns will be low. But the figures from the pension fund industry suggest that is not the case at all; cognitive dissonance is going on (a well-known behavioral trait).
The low level problem
Another way of saying that high valuations are justified by low interest rates. Equity is worth a stream of future cash flows, discounted to the present; as long-term yields fall, so does the discount rate, and the present value of equity rises.
But that only addresses one part of the equation, as a paper by strategist John Hussman argues.
If interest rates are low because growth rates are also low, then no valuation premium on stocks is “justified” by the low interest rates. Prospective results are discounted without the need for any valuation price.
In other words, if the discount rate falls due to slow growth, so should you expect future cash flows (profits). And future growth is likely to be slow given the demographics (flat or falling working-age populations in many western countries) and very low productivity growth (estimates for Britain have just been revised lower).
What has kept profits high, as Mr. Hussman says, is the shift in power between capital and labor during the financial crisis; a movement that has lowered wages and fueled the rise of populism. This cannot continue, he said:
There is no way to make the arithmetic work without assuming an improbable and sustained rise to normal economic growth rates, a near-permanent freeze in interest rates despite a full resumption of normal economic growth, and maintenance sustained near-record profit margins through sustained real wage growth, despite an unemployment rate that is now just 4.2%.
Again, investors seem to assume that past conditions will persist, despite the evidence. This behavioral bias will confirm that they are being made.
