Pessimism from a finance geek, 5/1

Antti Ilmanen on realized vs. expected returns

You can watch Antti Ilmanen here, or your can try his recent book, Investing Amid Low Expected Returns. On YouTube, he is hard to follow because of his accent. Also, he is a finance geek, a student of Kenneth French and Nobel Laureate Eugene Fama.

In his book, he argues for humility in investment. He says to remember that for every strategy you follow, there is always someone on the other side.

I noticed this playing fantasy baseball. There are some enthusiasts who insist on putting resources into getting top pitchers. Others insist on putting minimal resources into pitching. Some like to draft hitters that are superb in one or two categories. Others prefer hitters who are strong in several categories but not outstanding in any one. What you will find is that no strategy is automatically dominant. Whether a strategy works depends on the strategies of your competitors. If everyone else is over-valuing one type of player, then you have to find value in other types of players.

Let me offer my interpretation of what Ilmanen says about markets in general and the era that lies ahead.

For the broad stock market average (think of the S&P 500), you can think of the inverted price/earnings ratio as the expected real return, meaning what the investment community expects the stock market to yield after inflation. When the P/E ratio is 20, as it averaged for a long time, the expected return is 5 percent. When it is 40, which it reached before this year’s bear market, the expected return is 2.5 percent.

The expected return looks forward. The actual return is what you can observe in hindsight, looking backward. When the expected return rises, the actual return is reduced, and vice-versa. A rise in the expected return means that the P/E ratio falls. When you buy stocks and the P/E ratio subsequently falls, that lowers your real return.

In recent decades, we have experienced a secular decline in real interest rates, meaning interest rates adjusted for inflation. This has caused and/or been correlated with a drop in expected returns, thereby boosting realized returns. (A friend who has written a leading finance textbook let me know that this is very much the Fama-French story of high stock market returns. There are other stories.)

Another development that takes place as expected real returns fall is that the duration of assets rises. That is, it takes a smaller change in long-term interest rates to induce a large change in asset prices. If interest rates go up 1 percentage point, this will cause stocks to lose much more value if we start from where we are now (2.5 percent expected return) than if we start from 5.0 percent expected return.

Things that can’t go on forever, stop. Expected real returns cannot keep declining forever. If they stay frozen where they are, and if market forecasts of earnings are approximately correct, then actual real returns are likely to be close to expected real returns. That means that the real returns on the stock market will be lower than they have been in recent decades. Retirees and pension funds are not prepared for that. That is the Ilmanen’s primary theme.

But it could get worse. Perhaps expected real returns do not just freeze where they are, but they go up. Perhaps the market demands higher real interest rates. Then realized returns will be even below the current low expected real returns, which is the reverse of what we have gotten used to seeing. That is, twenty years ago, expected returns were relatively high, and actual returns exceeded expected returns. Going forward, we could have the opposite.

Why would the market demand higher real interest rates? Well, I have been saying that investors ought to be concerned about the inflation outlook, and this should cause real interest rates to rise. This will happen as financial market participants shift money out of low-yielding financial securities and instead into commodities, business inventories, or other tangible investments.

Maybe you have to be as old as I am, and/or a finance geek, to absorb all this. You may just think that stock markets will go up like they have during the era of falling expected returns. But we could be finally at an inflection point.