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Long Term Asset Return Study - Roadmap for the Grey Age |
14 Oct 2011. Jim Reid & Nick Burns from Deutsche Bank recently published their latest update to their Long Term Asset Return Study, entitled "A Roadmap for the Grey Age". It's important, when reading it to appreciate it that they're writing it from a US perspective. They say we've entered the "Grey Age", which contrasts with what they've dubbed the "Golden Age" from 1982 to 2007 when returns were generally higher than long-term averages.
Key takes from it are:
"The artificially long business cycles of the Golden Era are a thing of the past." (they were long as a result of the leverage super-cycle), and they expect a reversion to the average (over the last 157 years) expansion of 39 months and contraction of 17 months [Ed: it should be noted that there has been a fair amount of variation around this, for example expansions have varied from 10 to 100 months]. They therefore expect recessions around 2012, 2016 and 2020, which they believe will mean that "the 'Grey Age' is not for the buy and hold investor [Ed: These dates probably reflect too much precision, as they rely heavily on the average expansion and contraction periods carrying forward, which doesn't reflect the variability]. Trading around these regular business cycles will be key."
"If we are somewhere close to being correct in our analysis then equities will be stunningly cheap in the early years of the 2nd half of this decade... they may be at their normal secular 'once in a generation' buying opportunity levels from where returns will be phenomenal."
"The chart shows the S&P 500 PE ratio using Shiller's technique of smoothing earnings over the last 10 years (real adjusted) rather than using spot numbers. This helps to eliminate the cyclical bias and hopefully any secular bias where earnings may stay for a prolonged period above or below their long-term average relative to economic activity. As we can see there have been 4 valuation peaks over the last 130 years. After the first 3 the market took 16-20 years to finally re-rate higher from a valuation point of view after bottoming in the region of 5-8 times earnings......it's perhaps not unreasonable to expect the bottom in multiples to be put in place in the second half of this decade" (Ed: NB to look at Shiller's PE, as spot PE's don't give as clear a pattern).
"To show what a difference cyclically adjusted earnings make to the current valuation arguments, if we then convert these earnings series into simple PE ratios, the figure below shows that on spot earnings the S&P 500 trades at under 14 times earnings, slightly below the long-term average, but on the rolling 10 year cyclically adjusted series the PE is a more lofty 21 times earnings...So we can see how crucial it is to have a feel for the longer-term direction of earnings when trying to assess the long-term direction of equity markets. We are generally strong believers in eventual mean reversion across a large range of financial indicators/assets and therefore our base case is that earnings/profits will likely take up a lower share of GDP at some point in the future. If we are correct then current equity valuations look a lot less attractive than they do at first glance."
Profit margins are at or near all time highs and will eventually mean-revert, perhaps through the recession (earnings per share tends to lurche lower at or around the time the economy is in recession), the deleveraging cycle (less borrowing means less profit), potential corporate tax increases and an increased share of profit demanded by labour (perhaps through a disruption to globalisation).
Higher inflation may benefit equities through higher earnings growth (Ed: the link between inflation and higher earnings growth is tenuous, and it's questionable whether there'll be higher inflation and if there is, it may take some time). Also, PE valuations tend to fall when inflation is higher than 5%.
Demographics: Those aged 34-54 are generally accummulating assets compared to those younger and older who are generally exhausting their assets (or reducing the money those who are accummulating assets have to invest). So, shifts between the relative size of the 2 groups impacts the demand for equities. As the ratio of those accumulating assets in the US is expected to reduce relative to those selling assets, demand for equities may reduce over time.
Demand for government debt may crowd out equities (the excessive supply of government bonds draws investment away from equities), ensuring lower valuations.
(US Treasuries & other core Western Government bond markets) "offer no long-term value and should see negative real returns over the medium-longer term...we still expect inflation to be the eventual outcome due to aggressive money printing." The only possibility for positive returns is if there is a long flirtation with deflation, the possibility of which is higher in Europe than the US.
"Government yields are extremely low, cash rates close to zero, equities generally on the expensive side due to current peak earnings and commodities very rich relative to history", so what is one to do with one's money? "Clearly credit is one option, and although spreads have widened in the sell off, overall yield levels have actually fallen over the summer in many investment grade corporate sectors due to the sharp decline in Government yields. However in a difficult macro environment one would have to say that company balance sheets are a relative bright spot so some long-term exposure to spreads seems a relatively good risk/reward prospect. Given the fixed income and inflation outlook, it's perhaps also worth considering buying the same companies' equity and taking exposure to their dividends, growth and inflation protection qualities (this is more of a medium-term accumulation strategy as the secular equity bear market we think we remain in will ensure that the rewards do not necessarily emerge immediately). Indeed, the report shows that it's actually the highest rated companies that generally have the highest dividend yields. The more risky the company the more dividends are forsaken for the hope of future growth."
"In the near-term the recent HY sell-off has meant that the next recession has been partly priced in. Excess returns will still fall if we do see a 2012 recession but the impact will be relatively mild compared to the full cycle move. Going forward the analysis shows that excess returns can be very strong in the periods between recessions but very weak as we enter and navigate them. Given the likely frequency of these recessions, trading HY will be increasingly crucial to enhacing returns over the next decade. Timing is everything."
"Commodities have become very expensive...long-term investors have to be very careful with commodities, especially Gold".
"The labour force in China will start to shrink" from next year, and its ratio of asset accumulators starts to fall around 2015.
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