The Dow Jones and S&P 500 index are hovering around all-time highs.
The All Ordinaries index has risen 17% over the past six months.
Last weekend, auction clearance rates in Sydney and Melbourne were around 80%.
According to the Wall Street Journal, the US median house price has increased from US$155,000 in 2012 to around US$240,000.
Interest rates continue to plumb historic lows — most recently, the RBA taking our cash rate to 1.5%, and the Bank of England squeezing UK rates to 0.25%.
Rising markets and falling interest rates have created great expectations.
Global investment giant State Street Corporation (managing over US$2.5 trillion in assets) recently conducted a survey asking investors ‘What are your long-term (5 years+) return expectations for each of the following asset classes?’
Expectations are high…very high.
- Real estate — 10.9% per annum;
- Equities (shares) — 10.0% per annum;
- Commodities — 8.1% per annum;
- Bonds — 5.5% per annum.
The Rule of 72 seems to have been completely ignored in formulating these returns.
The easy way to determine how long it’ll take to double your money (on a compounding basis) is to divide the rate of return into 72.
A 10% rate of return means your money will double in 7.2 years.
Therefore, based on the survey results, investors are expecting the Dow Jones index to be around 37,000 points in 2024.
Even more bullish is the expectation for real estate…it will double in value in 6.5 years’ time.
And commodity prices (compounding at 8% per annum) will be worth twice as much in 9 years’ time.
As challenging as these numbers are for me to believe, the one that really took me by surprise was the rate of return for bonds…5.5% per annum.
On face value this looks like the most modest return expectation; however, it is totally disconnected from reality.
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When Great Expectations Lead to Great Disappointments
Government bonds — of all durations — are offering investors close to zero, or below zero, interest rates.
Corporate bonds — of good quality — are also paying next to sweet nothing to raise money from yield starved investors.
The corporate junk bond market — where there’s a question mark over whether you’ll be paid interest and/or your capital back — is paying upwards of 6% per annum.
So, to get to 5.5% per annum, either you load up on junk bonds and hope for the best, OR you punt on interest rates falling further over the next five year to provide a capital gain kicker to your zero or negative interest-paying government bonds.
Wow, that’s some hairy chested assumption.
In the investing world, you tend to find that expectations are nothing more than extrapolations. What has been will continue to be.
But if life and markets worked that way, we would never have cycles. Night would never follow day, and booms would never bust.
For example, Japan’s economic growth from 1956 to 1973 averaged 9.4% per annum. After 17 years of exceptional growth, the expectation would be for this to continue. Not so. From 1973 to 1990, growth fell to 4% per annum. Since 1990, Japanese economic growth has been almost zero.
In 1968, the S&P 500 index was 100 points. In 1982, the S&P index was 100 points. For 14 years, the US market went nowhere. The next 18 years were a completely different story. In 2000, the S&P 500 index topped out at 1500 points…a 15-fold increase. Since 2000, it’s been a tougher slog for the S&P 500. The tech wreck and GFC were formidable forces to combat. Over the past 16 years, the S&P index has managed a compound return slightly above 2% per annum.
Markets, economies and empires are all cyclical. Nothing ever stays the same.
Since 2009, global asset prices have been boosted significantly by lower interest rates — and an embarrassment of liquidity.
However, the underlying economy has not strengthened in any meaningful or lasting way. Yes, there are the occasional good employment numbers, but these are quantitative — not qualitative. If a $100,000 job is replaced by two that pay $25,000 each, in theory, you’ve increased employment, but the economic contribution has been cut in half. This is what’s happening in the jobs market. Household income is not rising and, accordingly, spending is being constrained.
After several years of using accounting trickery to boost earnings, US corporates are running out of rabbits. The latest batch of earnings data is more reflective of actual business activity.
‘Analysts tracked by Bloomberg have lowered forecasts by 2.9 percentage points since the end of June and now anticipate profits will contract by 0.6 percent in the third quarter, putting U.S. large-cap stocks on track for the longest profit slump since the financial crisis. Forecasts were cut for nine of the 10 main industries, with prospects for energy and industrial companies worsening the most.’
— Fortrend Securities, 8 August 2016
It is impossible for ALL companies to grow earnings in a slowing economy. Every economy — even China — is registering lower GDP growth.
Growth rates from the golden ‘credit infused consumption’ days are a distant memory.
Therefore, without above-average earnings growth, how do you get to an expected annual return of 10% per annum? Price earnings expansion can be the only answer.
Yet market PE multiples for major indices are approaching all-time highs. Those infamous periods in the market’s history — prior to The Great Depression, the bursting of the tech bubble, and the 2008 credit crisis.
Optimism reigns supreme at the height of a market. When investors — completely divorced from mathematical reality — are prepared to pay higher and higher multiples for less and less earnings.
GMO (Grantham, Mayo, Van Otterloo & Co.) — to put it mildly — are simply brilliant at producing forward forecasts for various asset classes. GMO uses mathematical models — reversion to the mean — rather than emotion to formulate their uncannily accurate return expectations.
‘There is no panacea for the low returns implied by asset valuations today. Anyone suggesting differently is either fooling themselves or trying to fool you. But piling into the assets that have been the biggest help to portfolios over the past several years, as tempting as it may be, is probably an even worse idea than it usually is.’
— Ben Inker, GMO
That last sentence should be a warning to all thinking investors — piling into yesterday’s winners, and expecting them to reproduce yesterday’s results, is a really dumb idea.
What’s the worst performing investment in recent years?
A contrarian investor would be piling into cash, while the herd believes other asset classes are going to replicate their recent stellar results.
In my experience, great expectations tend to lead to great disappointments.
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