On Drivers of Equity Returns, Forecasting Equity Returns and Thinking Yourself Well!

From Aditya RanaDate: Sat, Dec 15, 2012 at 2:40 PM
Subject: On Drivers of Equity Returns, Forecasting Equity Returns and Thinking Yourself Well!


Investors around the world have become disillusioned with equities, given their dismal performance over the last four years ( and longer for developed markets). This has been reflected in the significant out flows from equity mutual funds into bond funds in recent years. However, as we near the end of the three decade bond bull run, investors should be looking at increasing (not decreasing) their allocations to select equities at the expense of bonds. In support of this view it is important to understand what are the drivers of equity returns, and what we can expect them to be over the next 5 to 10 years. With this aim in mind I bring to you a brilliant note by Saumil Parikh, Head of Asset Allocation at PIMCO, which not only provides a unique perspective on the topic but also dispels some common misunderstandings (i.e. that GDP growth has no impact on equity returns) . To summarise:

-All financial assets (stocks, bonds, cash) derive their returns from the performance of real economic factors (capital, labour, materials and the productivity of these inputs).

-GDP and its growth rate is the ultimate source of all cash-flows and retuns which trickle down to cash, bonds and stocks based on their individual place in the capital structure.

-Equities derive their unique risk characteristics from the ups and downs of multi-factor productivity growth, as they are the most junior in the capital structure and therefore capture the “unlimited” upside (profits) left over after the cost of labour, material and credit which are rigid in the short-term.

-With unlimited upside comes downside risk, particularly if economic growth (amongst other factors) surprises on the downside leading to significant risk and a possibility of permanent loss of capital.

-Over the last 110 years, a typical “market portfolio” comprising cash, inflation, UST bonds and equities have delivered a return of 35% per unit of risk – i.e. an increase in return of 0.35% for every 1% increase in risk.

-While low volatility assets like cash and treasury bonds have delivered returns which have limited upside and downside and fairly symmetrical distributions over both the short-term and long-term, equities have delivered returns with considerable upside over both the short-term and long-term but with significant downside only over the short-term.

-Equity returns can be decomposed into 1) returns from income, 2) returns from growth, and 3) returns from valuation changes. Over the last 100 years, nominal returns from income and growth were approximately 5% each, while returns from valuation changes were zero. Over shorter time periods, market inefficiencies and gyrating “animal spirits” created significant opportunities for disciplined value investors.

-Returns from income which derive from dividends and stock repurchases, have been fairly stable over time, and adjusting dividend yields by the fluctuating pay-out ratio is a helpful way to forecast the return from income over time.

-Returns from growth are derived from two factors with the first factor-nominal GDP growth – being the most important. For periods greater than 5 years, the relationship between GDP growth and earnings growth becomes clear, stable and consistent. Dividend growth and earnings growth in aggregate equal GDP growth over 10-year cycles.

-The second factor driving returns from growth are the share of aggregate corporate earnings in GDP. From national accounting we can derive the following important identity:

Total corporate profits = total investment less household savings, less government savings , less foreign savings.

-In recent years, the rising corporate profits share of GDP has been produced mainly due to the large reduction in government savings (i.e increase in the deficit) as a share of GDP, which has offset the falling share of investments in GDP.

-Returns from valuation changes , over the long-term, should be zero mainly because equity prices have tended to tracked equity prices resulting in a mean-reverting character for valuations (price-to-earnings ratio).

-Professor Robert Shiller has provided a useful insight: since earnings are very volatile year to year (twice as volatile as equity prices), and equity prices derive their anchor from these volatile earnings, a cyclical adjustment is useful in reducing the volatility of earnings so that they can provide a useful anchor for equity prices.

-While initial valuations drive forward returns due to the mean-reverting nature of p/e ratios over time, equity returns are also positively impacted when GDP growth rates are stable (between 2% and 6% ). This is because both volatility of growth and earnings is higher at extremes levels of growth , as well as negative growth results in permanent loss of capital while high growth is associated with rising credit costs.

-To forecast future equity returns, the three components of equity returns are further segregated into the following expression:

10-year trailing equity returns = initial payout-adjusted dividend yield + nominal GDP growth + annualised change in profits share of GDP+annualised change in cyclically adjusted p/e ratios + annualised change in real long-term treasury yields – 1.8% (equity dilution factor).

-With expected nominal GDP growth rate of 4% to 5% (due to adverse demographics and productivity decline), payout-adjusted dividend yields of 3.7%, an annualised decline in corporate profits share of GDP of 0.25% to 0.5%, a lowering of cyclically adjusted p/e ratios from the current level of 21 to 17, a gradual rise in real long-term treasury yields from -0.6% to 0.5%, the forecast return for the U.S. equity market is 4.0% to 5.1% over the next 5 to 10 years which is significantly lower than the 10% nominal returns achieved historically.

-Some important “unknown unknowns” which could have a significant impact on returns:

-positive impact on growth from productivity and technological progress, especially in the areas of alternative energy sources and molecular biology.

-negative impact on profit’s share in GDP due to increased crystallization of unfunded liabilities on the balance sheet (i.e. higher structural deficits).

-impact on valuation change due to extension of financial repression and zero rate policy which can sustain high p/e multiples and adverse demographics leading to lower savings and either lower investment or a reliance on costlier imported capital.

-the implied survivor bias in the historical analysis as U.S. equity returns over the last 110-years has been higher than in other developed and developing markets primarily because the U.S. has not faced a major destruction of capital as other countries have.

Fascinating note, and highlights the importance of rebalancing portfolios towards equities rather than bonds (higher relative returns as the interest cycle reverts), high growth markets (i.e. equities in EM) and asset classes which will be beneficiaries of EM growth (i.e. energy and natural resources).

Think yourself well (The Economist – December 8):

Fascinating article in last week’s Economist on recent research which provides evidence of the link between the mind and the body, and more specifically how positive emotions work in enhancing a specific nervous system which has been known to be associated with better health. Additionally, how meditation has a positively reinforcing impact on the specific nervous system.

The link between mind and body is terrain into which many medical researchers, fearing ridicule, dare not tread. But perhaps more should do so. For centuries, doctors have recognised the placebo effect, in which the illusion of treatment, such as pills without an active ingredient, produces real medical benefits. More recently, respectable research has demonstrated that those who frequently experience positive emotions live longer and healthier lives. They have fewer heart attacks, for example, and fewer colds too.

Why this happens, though, is only slowly becoming understood. What is needed is an experiment that points out specific and measurable ways in which such emotions alter an individual’s biology. And a study published in Psychological Science, by Barbara Fredrickson and Bethany Kok at the University of North Carolina at Chapel Hill, does precisely that.

Dr Fredrickson and Dr Kok concentrated their attentions on the vagus nerve. This nerve (illustrated right, in an early anatomical drawing) starts in the brain and runs, via numerous branches, to several thoracic and abdominal organs including the heart. Among its jobs is to send signals telling that organ to slow down during moments of calm and safety.

How effectively the vagus nerve is working can be tracked by monitoring someone’s heart rate as he breathes in and out. Healthy vagal function is reflected in a subtle increase in heart rate while breathing in and a subtle decrease while breathing out. The difference yields an index of vagal tone, and the value of this index is known to be connected with health. Low values are, for example, linked to inflammation and heart attacks.

What particularly interested Dr Fredrickson and Dr Kok was recent work that showed something else about the vagal-tone index: people with high tone are better than those with low at stopping bad feelings getting overblown. They also show more positive emotions in general. This may provide the missing link between emotional well-being and physical health. In particular, the two researchers found, during a preliminary study they carried out in 2010, that the vagal-tone values of those who experience positive emotions over a period of time go up. This left them wondering whether positive emotions and vagal tone drive one another in a virtuous spiral. They therefore conducted an experiment on 65 of the university’s staff, to try to find out.

They measured all of their volunteers’ vagal tones at the beginning of the experiment and at its conclusion nine weeks later. In between, the volunteers were asked to go each evening to a website especially designed for the purpose, and rate their most powerful emotional experiences that day. Dr Fredrickson and Dr Kok asked their volunteers to consider nine positive emotions, such as hope, joy and love, and 11 negative ones, including anger, boredom and disgust. They were asked to rate, on a five-point scale, whether—and how strongly—they had felt each emotion. One point meant “not at all”; five meant “extremely”. In addition, half the participants, chosen at random, were invited to a series of workshops run by a licensed therapist, to learn a meditation technique intended to engender in the meditator a feeling of goodwill towards both himself and others. This group was encouraged to meditate daily, and to report the time they spent doing so.

Dr Fredrickson and Dr Kok discovered that vagal tone increased significantly in people who meditated, and hardly at all in those who did not. Among meditators, those who started the experiment with the highest vagal-tone scores reported the biggest increases in positive emotions. Meditators who started with particularly low scores showed virtually no such boost.

Taken as a whole, these findings suggest high vagal tone makes it easier to generate positive emotions and that this, in turn, drives vagal tone still higher. That is both literally and metaphorically a positive feedback loop. Which is good news for the emotionally positive, but bad for the emotionally negative, for it implies that those who most need a psychosomatic boost are incapable of generating one. A further (as yet unpublished) experiment by Dr Kok suggests, however, that the grumpy need not give up all hope. A simpler procedure than meditation, namely reflecting at night on the day’s social connections, did seem to cause some improvement to their vagal tone. This might allow even those with a negative outlook on life to “bootstrap” their way to a mental state from which they could then advance to the more powerful technique of meditation.

Whether, besides improving general health, the mechanism Dr Fredrickson and Dr Kok have discovered helps explain the placebo effect remains to be investigated. But it might, because part of that effect seems to be the good feeling engendered by the fact of being treated. More generally, doctors in the ancient world had a saying: “a healthy mind in a healthy body”. This sort of work suggests that though this proverb is true, a better one might be, “a healthy mind for a healthy body”.

Happy meditating!

I will be travelling (India) over the next two weeks so the next newsletter will be on January 12, 2013). Wish my readers Happy Holidays and may 2013 bring good health and prosperity!



PIMCO Asset Allocation Focus November 2012-equities.pdf


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