Business

Saturday August 18, 2012

High returns are the real false cult

COMMENT By JAMES SAFT


It may not be just the cult of equity which is dead, it may be the cult of investment

PIMCO'S Bill Gross, a bond guy if ever there was one, proclaimed the death of equity worship recently, proposing that the 6.6% real return equities have enjoyed since 1912 was not just an aberration but a flaw of common sense like “a Ponzi scheme”.

Gross is both right, wrong and then right again, arriving, like so many of us, at more or less the right place through an errant path. He's absolutely right in that there is a risk that for many investors, over the time frames which are meaningful to them, equities may prove a huge disappointment, just as they have these past 10 to 15 years.

He's dead wrong, however, in one important plank of his argument; that equity returns cannot mathematically outpace GDP indefinitely.

As Ben Inker, of fund managers GMO, patiently explains, not all of those gains are compounded indefinitely; a huge but unknown proportion gets spent.

That means there is no Ponzi scheme. GDP growth sets a backdrop, but the specific action driving stock markets are valuation changes, earnings growth and dividends.

“There is a difference between expecting low returns due to reversion to long-term normal valuations and expecting low returns because something has fundamentally changed about the return-generating process for equities,” Inker, head of asset allocation at GMO, wrote in a note to clients.

Equities have returned more, and very likely will return more in future, because they carry more and different risks to other parts of the capital structure like senior and convertible debt. Equities, as many readers will attest, can really screw up your plans; plunging at just the wrong moment, such as when you are about to retire or, as is so often the case during economic downturns, when you have just lost your job.

(As a side point, these discussions always exclude the returns of those who lost major wars during the last century. The long-term returns of German and Japanese equity holders presumably was quite a bit lower than that 6.6% figure.)

Relative risk

That higher risk means that equities must, in the long run, be a good investment in order for companies to be able to attract capital, which presumably they will continue to need to do.

That's quite a different thing from saying that they are going to offer good returns in the near future, or whatever your preferred investment horizon happens to be. If you are not an endowment investing for eternity, this may well not be your time.

Gross, correctly, points out that corporate profits, as a share of GDP, are at an all-time peak. Wages in the United States have been stagnant in real terms for four decades, and it would not at all be a surprise to see workers win a bigger part of the pie in the next few years.

We may be coming towards the end of the period both of increased globalisation, and of cheaper labour from overseas flattering profits, both developments which would be bad for returns.

So it's quite sensible to expect a re-rating of equities downward over the next few years, as shares seek and ultimately find a point at which they represent good value and can begin their own reversion to mean.

The point is that it may be, at least for five or 10 years, sensible to expect relatively low returns in all of the traditional asset classes. A huge amount of debt needs to be digested globally and the two routes, inflation and debt deflation, are both threats to returns.

The cult of equities is part of a broader cult of investment, which takes as its central belief that we can, if only we choose the right manager and right product, outrun, or even bankroll, our own profligacy.

The huge underfunding of corporate, state and private pension plans is the best evidence that this cult exists and that we should leave it.

Returns, for a time, are going to be low, almost across the board. Savings are going to have to rise. This implies a bit of a vicious circle, as one feeds the other, so this period might last longer and be a bit worse than otherwise we would expect.

Equities, in the end, will outperform cash and bonds, but many of us simply won't be able to afford to take too much of that kind of risk.

l James Saft is a Reuters columnist. The opinions expressed are his own.

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