Here we are in the second half of the calendar year. And the last three years give you absolutely no clue about what to expect. Today’s Markets and Money endeavours (to persevere) and to determine the future of corporate cash flows and the equity risk premium in emerging markets. But let’s start closer to home with a brief history of the last three second halves of the calendar year.
In the second half of 2007 – for the six months between June 1st and January 1st – the All Ordinaries finished essentially flat. In 2008, that six-month period in the second half captured some of the shock-horror of the GFC, with the All Ords down 38%. But the liquidity driven rebound of 2009 saw that same six-month period deliver a 25% gain on the index.
So in this case, history teaches us nothing, except to expect volatility. Morgan Stanley analysts say that the range-bound Aussie market could deliver some volatile profits, if you’re willing to load up on risk. In other words, it will pay to add risk now, according to the Morgan analysts.
“We continue to think now is the time to add back risk to equity portfolios, given cheap valuations on 2011 earnings,” writes equity analyst Toby Walker. “Having said that, we think range-bound and volatile markets could continue near term before a final quarter rally towards our year-end index target of 5207 [on S&P/ASX 200].”
A lot depends on what you think 2011 earnings will be. And that depends on how much growth in the real economy – if it grows it all – comes from confident consumers and business and how much comes from government-generated stimulus (less and less). The bear case is that the growth will come from neither, making it “not-growth”, or “contraction” as some of us call it.
More out of curiosity than anything else, we ran a five-year chart of the All Ordinaries this morning to see what the gross return would have been for a buy-and-hold investor. The results are in the chart below, and they’re not so flash. But then, it’s been a pretty bad five years. If you start that same chart in 2009 and roll it forward through 2014, what do you reckon it will look like?
Using rolling five-year periods to determine the performance of equity markets is a favourite technique of people who tell you to buy and hold stocks for the long run. The embedded premise – which may or may not be borne out by the data – is that the longer you hold stocks, the less risky they are. Therefore, a buy-and-hold technique is the best strategy for dealing with unpredictable preiods of volatility. Set and forget!
But that strategy will turn out to be a dud if any one of several scenarios turn out to be true. For one, there is the “weight of money” argument here in Australia. With retirement contributions being compulsory, there’ an argument to be made that the share market will always push higher because it’s fed by a captive stream of money that flows only one way and generally into one asset class.
It will be interesting to see how fund managers behave in the coming years. For the most part, fund managers buy shares because it’s what they get paid to do, the way bakers bake bread and chandlers make candles.
True, buying stocks because it’s what you’re expected to is not terribly imaginative. But in a world of relative returns – where your performance is judged on matching the index – it’s almost a self-fulfilling argument: buy the same stocks everyone else is buying and you’ll at least match the market. Chandle away by day and drink mojitos by night.
That works out well for the fund manager, but maybe not as well for the individual investor (especially if you don’t like mojitos). But the individual investor does have an advantage over your average institutional fund manager: he can think freely and act independently.
If he’s a thinking man’s investor we think he’ll ask himself something like the following question: will stocks consistently deliver a rate of return over and above the so-called risk-free rate of return in government bonds in the next ten years?
This question about the equity risk premium – what stocks are expected to return over long-term government bond yields – is an especially fascinating question right now. Right now, investors are absolutely in love with long-term government debt. This is one way of saying that they expect a much lower equity risk premium in the coming years. But what does that mean?
Well, stocks can only pay dividends or grow earnings by growing their business. And a company can only grow its business if people are spending money. A lower equity risk premium means investors expect lower earnings growth. And it should follow that lower corporate earnings growth in the aggregate should mean lower GDP growth.
All of this, by the way, is an inherently deflationary argument. Asset prices fall as the equity risk premium collapses. The balance sheet recession in which households and businesses pay off debt, increasing saving, and reduce spending, becomes the balance sheet depression and stocks fall further. This is the scenario in which investors begin to choose a fixed income strategy – a regular payment from a creditor – over equities.
Mind you, we still find it mind-bogglingly stupid that investors would loan money to the United States government over a long-period of time and expect to beat inflation. To be fair, maybe that’s not what’s going on. As a trade, if you believe the austerity measures by the public sector will combine with the deleveraging of the private sector and households, then yes, bond prices could go higher as stocks go nowhere. This, however, is a play for capital gains from bonds and not a true income strategy.
None of that answers the question of whether the equity risk premium will rise or fall in the coming years. We reckon it will fall, but not because sovereign bonds are truly “risk-free.” They’ve never been riskier. Investors crowding into them now are setting their saving up to be consumed when the Feds unleash inflation. But we’ll save that argument for later this week.
For now, we had hoped to go back and cite a study we’ve previously analysed that looked at corporate cash flows in the post World War Two era. It showed, if we recall correctly, that corporate cash flows were anomalously high in that period, mostly as a result of the Baby Boomers, instalment credit, and the gradual establishment of the dollar standard. It showed that cash-flows were set to mean revert, meaning a lower equity risk premium for the next generation of investors.
In other words, several generations of corporations and roughly fifty years of corporate earnings benefitted enormously from the population boom of the post-War period. That boom itself led to a consumption boom, driven both by demographics – a large percentage of the population with growing incomes and access to credit – which led to even higher earnings.
But in the Western world, at least in America, real average income growth hasn’t improved much since 1974. Households have increasingly borrowed against home equity and stocks to finance consumption. And even all that seems to have hit the proverbial wall in the last few years. Mean reversion alone would argue for lower aggregate corporate profits. Mean reversion plus demographics (ageing populations) plus credit depression conspire to predict lower earnings too.
We’ll wind up, though, with two qualifiers. You are not required to buy the stock market. But you can choose to buy certain stocks. And even in an economy with ageing workers and mean-reverting corporate cash flows, some businesses (like healthcare and probably energy) will see earnings growth. Equity investors may be willing to pay an even higher risk premium for those earnings outperformers in future years.
But all along we have been referring, in a general, to equity risk premiums in Anglo countries that benefitted from the same post-War trends of a booming population, pent up demand for durable and consumer goods, access to credit, and assets up on which further consumption could be financed. What about China and India for Australia?
That is, can and should you as an Australian investor allocate a larger portion of your equity portfolio to shares in emerging markets? Those markets are driven by some of the same forces – rising levels of consumption and access to credit – that drove corporate-cash flows so high for so long in Western markets.
Is there a responsible way to capture some of those rising cash flows as an equity investor – if indeed they exist? We’ll take up the subject of alpha and beta and asset allocation tomorrow. Until then…
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