Risk Premiums Get Scary

John Mauldin | Thoughts from the Frontline
May 3, 2002

What a week. A whirlwind tour through Southern California visiting clients has left me quite tired, but driving through ridiculous freeway traffic has given me a lot of thinking time. I needed it, as I have been meditating in the implications of a very important new article in the AIMR Financial Analysts Journal. It is a lengthy and devastating analysis of what investors should expect by way of returns in the stock market over the next decade or so. I will do my best to give you the highlights.

Plus, there has been a lot of data which has serious implications for my prediction of a Muddle Through Economy. I have been mulling over where to start, and I think we will begin with the AIMR article by Bob Arnot and Peter Bernstein. AIMR is a very mainstream organization of analysts and economists and NOT prone to bearish sentiment. The fact that this article is in this journal is significant.

(Bernstien wrote a magnificent book on the history of risk called Against the Gods which is extremely readable, even though the topic of risk can be complex. The AIMR article is still password protected, though as soon as it is publicly available, I will provide you with a link.)

Investor Expectations

I have written in the past about investor expectations. Many individual investors, based upon the past two decades, assume they can get 15% per year in the future. Most major corporations assume their pension portfolios will grow 9-10% or more in the coming years. By the way, these assumptions add to their projected corporate earnings. If their pension portfolios grow at less that those rates, they will have to re-state earnings downward and lower future estimates.

A drop of only a few percent in stock market growth expectations can lower future earnings estimates at many companies by as much as 10%. To me, the AIMR article says you can bank on earnings estimates to be dropped as a result of exuberant projections. You should check to see if the stocks you own are making aggressive assumptions.

How many times have you had a stock broker quote you the Ibbotson Survey or something similar which shows the stock market growing 8% per year over long periods of time? All you have to do is just keep the faith and buy and hold. You should especially never sell their funds.

Bernstein and Arnot show that this number is VERY misleading. If you break it down, it shows you something entirely different.

First, the largest component of stock market return, up until 1982, was inflation. From 1802 to present, $100 would have grown to $700 million if you assumed all dividends re-invested. However, if you take out inflation, we are left with a still impressive $37 million. If you take out dividends, however, you find that your $100 is only worth $2,099!

Here's the kicker: in 1982, the stock portfolio would have been worth only $400. The bulk of the growth, over 80% of current value, came in the last 20 years.

This data simply says that conventional wisdom which says equities get most of their value from capital appreciation is false. It is based upon recent experience, and a bubble mentality.

Risk Premiums

Conventional Wisdom says stocks yield a risk premium of 5% over bonds. You can look at the returns of the last 75 years and demonstrate that fact. But in 1926, when you looked at actual expectations, based upon then current yields, the risk premium (that amount by which stocks were expected to out-perform bonds) was only 1.4%. Investors in 1926 did not expect to get 5% over bonds over the next 75 years.

But they did. The question one has to ask is why did this happen and is it likely to repeat itself?

Bernstein and Arnot says the increase in returns was due to a series of historical accidents. The first was a "decoupling" of yields from real yields. By that they mean that the coming of inflation changed the way in which bonds were valued. In essence, in 1926, and for years after that, bond holders assumed no inflation. Bond-holders began to demand more in order to compensate for the risk of inflation. In fact, real returns on bonds were often negative after WW II. That means inflation was higher than the yields on the bonds. That change in the way bonds were valued accounted for almost 10% of the increase in the "risk premium" from 1926 to present.

Secondly, valuation multiples rose dramatically. From a level of 18 times dividends in 1926, we now see dividend multiples of over 70. This means that a dollar of dividends is valued at over 4 times what it was 75 years ago. However, the entire increase has happened in just the last 17 years. Not coincidentally, this was when we had a bubble. This accounts for over 1/3 of the increase in the risk premium.

Why were investors willing to take so little risk premium for stocks over bonds in 1926? Because they did not believe there was "0" risk in living in America. There were still those who remembered the Civil War. Four of the largest 15 stock markets in the world had completely collapsed within recent memory, with many others coming close to collapsing. The US was not the pre-eminent world power it has become the last two decades. Historical accident number three is that investors have become increasingly confident in America. This is a good thing, I think, but how likely is it that we are going to grow even more confident from where we are today. Using a rough analogy, let us say that we have grown 4 times more confident in the future of America over the past 75 years in terms of being confident in bonds and stocks. Is it likely we will grow another 4 times? Thinking back from what the world looked like in 1926, seeing where we have come and trying to extrapolate that sense of growth in security into the future, it think it is very unlikely we will feel significantly better in the future than we do today.

Finally, regulatory reform has done much to increase returns in the stock market. In the early parts of this century, management would routinely vote themselves more stock if a company did well, diluting current investors, and keeping rates of return low. This changed as securities laws were introduced. This has been a very good thing, but is not likely to be repeated.

In short, the events which led to the significant increase in the value of stocks over bonds were basically one time events, and not likely to be repeated. It is very unlikely that this trend will continue. Yet that is what would have to happen if the Dow were to get to 25,000 by 2010 as some predict.

If the risk premium reverts to more normal measures, then either the stock market, or the bond market, or both, are in for some turmoil. (See details below.)

The authors show that earnings and dividend growth for the past two centuries is far less than the forward earnings expectations most analysts have today. Interestingly, this study uses a different way to analyze earnings than the National Bureau of Economic Research that I cited last year, but both conclude that total market earnings will not grow faster than the economy.

Let's look at some of their direct conclusions. This is a rather long quote, but it is critical. If you grasp what they are saying, you could save yourself a lot of investment grief over the coming decade.

"The historical average equity risk premium, measured relative to 10-year government bonds as the risk premium investors might objectively have expected on their equity investments, is about 2.4%, half what most investors believe. The "normal" risk premium might well be a notch lower than 2.4% because the 2.4% objective expectation preceded actual excess returns for stocks relative to bonds that were nearly 100 bps higher, at 3.3% a year.

"The current risk premium is approximately zero, and a sensible expectation for the future real return for both stocks and bonds is 2-4%, far lower than the actuarial assumptions on which most investors are basing their planning and spending."

Predicting a 50% Drop

Then we come to the meat of the matter:

"On the hopeful side, because the "normal" level of the risk premium is modest (2.4%or quite possibly less), current market valuations need not return to levels that can deliver the 5% risk premium (excess return) that the Ibbotson data would suggest. If reversion to the mean occurs, then to restore a 2% risk premium, the difference between 2% and zero still requires a near halving of stock valuations or a 2% drop in real bond yields (or some combination of the two). Either scenario is a less daunting picture than would be required to facilitate a reversion to a 5% risk premium.

"Another possibility is that the modest difference between a 2.4% normal risk premium and the negative risk premiums that have prevailed in recent quarters permitted the recent bubble. Reversion to the mean might not ever happen, in which case, we should see stocks sputter along delivering bondlike returns, but at a higher risk than bonds, for a long time to come."

They then conclude, "The consensus that a normal risk premium is about 5% was shaped by deeply rooted naivete in the investment community, where most participants have a career span reaching no farther back than the monumental 25-year bull market of 1975-1999. This kind of mind-set is a mirror image of the attitudes of the chronically bearish veterans of the 1930s. Today, investors are loathe to recall that the real total returns on stocks were negative for most 10-year spans during the two decades from 1963 to 1983 or that the excess return of stocks relative to long bonds was negative as recently as the 10 years ended August 1993.

"When reminded of such experiences, today's investors tend to retreat behind the mantra "things will be different this time." No one can kneel before the notion of the long run and at the same time deny that such circumstances will occur in the decades ahead. Indeed, such crises are more likely than most of us would like to believe. Investors greedy enough or naive enough to expect a 5% risk premium and to substantially overweight equities accordingly may well be doomed to deep disappointments in the future as the realized risk premium falls far below this inflated expectation."

"Hopeful" Outcomes

I smiled when I read their concept of a "hopeful" outcome. It gives a new meaning to the word hopeful. Their view of hopeful is only a 50% drop in the stock market or a dropping of long term rates to levels which imply outright deflation. Or we would see a Muddle Through Market, with stocks going sideways for many years.

What could make their scenario wrong or irrelevant? They could be wrong about earnings growth. Earnings could grow rapidly, and thus valuations drop back to normal levels without the pain suggested in their study. Many analysts think earnings are going to rebound dramatically in the near future.

However, my friend Gary Shilling points out in his recent newsletter that this is not likely. For stock valuations simply to come back to the mean, earnings would have to grow at 38% in 2002 and 38% in 2003 to get back to an operating earnings P/E of 15.

Shilling does a relatively straight-forward analysis to show that this would mean a rise in the GDP of 13%, which he says appears patently impossible. In order for such an event to happen, labor would have to be willing to give back wages and consumers would have to be willing to pay a LOT more for products. The Texas Rangers will be in the World Series before these happen.

In fact, the data shows that the economy is much more likely to grow around 2.5% for the year. That is not bad, but it is not enough to help corporate profits grow back to the levels forecast by Wall Street analysts. Abbey Joseph Cohen still thinks the S&P 500 is going to 1300. She is wrong.

Dollar Merry-Go-Round

All this has profound implications for the dollar. One of the hottest and most interesting current debates among economists is about the value of the dollar. Dollar bulls say that the rest of the world will continue to buy our stocks, bonds and assets. Why should demand for the dollar change? They have been right for a long time, as those who worry about our trade deficit have been wrong in predicting a crash in the dollar. Why should the next few years be any different than the past?

For the record, I have been bullish on the dollar for many years, up until recently. What has made me change my mind?

The "current accounts deficit" is approaching critical mass. Think of it this way. If you spend more than you make, you have to do something to make up the difference. You can sell the furniture, borrow money, hock the kids, get a second job and so on. If you do nothing, you will soon be bankrupt.

On a macro scale, it is not much different for governments and currencies. We are buying more products from overseas than we sell. To make up the difference, foreigners have bought our companies (called mergers and acquisitions or M&A), bought our stocks and bonds and sometimes bought our currency (in the form of bonds and t-bills).

Much of the M&A has been from Europe. This has been drying up at an alarming rate in the past few months (see below). It is almost like Europeans smell blood, and realize they will be able to get the US assets cheaper in the future if the dollar drops.

The longer this stock market goes sideways, the less enthusiastic the world will be with US equities. If you are not convinced the dollar is going up, you will invest in your own currencies or in Euros.

Morgan Stanley analysts Jen and Yilmaz point out that if the world shifts from the current equity regime to a bond regime (their word) that the dollar would go from being slightly over-valued to dropping by as much as 15-20%.

In other words, if Bernstein and Arnot are right and investors are going to become increasingly interested in the absolute returns, then the dollar is at real risk.

And then one of my favorite analysts, Stephen Roach, weighs in with these thought-provoking words:

"Never before has the United States commenced economic recovery with a current-account gap totaling 4% of its GDP. (They predict it will rise to 6% in 2003, although Fed studies show that when the trade gap gets to 5%, serious problems will develop - JM) Given the high level of import penetration now structurally embedded in the US economy -- with goods imports at 30% of GDP in early 2002 -- another stretch of US-led global growth will most assuredly result in a significant further widening of the external shortfall.

"If such a massive external funding requirement doesn't lead to a saturation of the foreign appetite for US assets, I'm not sure what will. Just because America's external financing was manageable in the 1990s doesn't mean it will be so as the as the ever-widening current-account deficit now ups the ante on capital inflows. Needless to say, that conclusion is in direct contradiction to that of the capital-flow-driven justification of the Bush Administration.

"Interestingly enough, there are signs suggesting that this point of saturation may now be at hand. As Joe Quinlan and Rebecca McCaughrin have recently noted, the portfolio portion of capital inflows into the United States has slowed dramatically in early 2002. Over the first two months of this year, foreigners purchased just $27 billion of dollar-denominated assets, a dramatic reduction from the $100 billion pace in the first two months of 2001.

"Meanwhile, foreign direct investment into the United States -- the other major piece of the capital inflows equation -- has also slowed dramatically. FDI into the US was $158 billion in 2001 -- only a little more than half the $295 billion average pace of 1999 and 2000. Fully two-thirds of this slowdown is traceable to diminished FDI activity from Europe; that's largely a reflection of a dramatic downshift in the cross-border M&A cycle -- a trend that has continued into the early months of 2002.

"I remain convinced that America's current-account deficit represents a key point of tension for the US and global economy. It is the crux of our "global decoupling" thesis -- that the world can no longer afford to be dependent on the American growth engine as the dominant source of economic growth. The coming US current-account adjustment speaks of a new recipe for sustained global growth -- a slower pace in the US, a speed-up elsewhere, and a weaker dollar. The logic of the Bush Administration is flawed in the sense that it relies on an ever-expanding stream of foreign inflows into dollar-denominated assets. In this post-bubble era, that may well turn out to be the ultimate in wishful thinking."

The dollar is headed down, and perhaps the beginning of the drop is sooner than I had previously thought. You can open foreign denominated CDs in the Euro or other currencies at Everbank right here in the USA. Just click here to view their information page.

One of several things will have to happen over time. We will have to decrease our purchase of foreign goods, although since so much is manufactured overseas, this is not a short-term solution. Foreign purchase equal to 30% of GDP is huge.

If the dollar drops, manufacturing and production will come back into the country, as it will become cheaper to produce things here. Just as we enjoy cheap foreign products, the drop in the dollar will make our products cheaper in terms of foreign currencies, and so we will sell more of them.

The US will still be the premier world economy for some time (decades and decades) to come, and foreign companies will want to have a presence here, and will buy our companies and assets, which will help balance the current accounts deficit.

All these should keep the dollar from the crash that many predict, but will not save it from the 20% drop that the Morgan Stanley analysts predict. How soon will all this happen? I don't know, and neither does anyone else. If I say in the next year or so, it is just a guess, and that is my guess. Many analysts hazard a guess which they call a prediction, in case they might be right. If they are, they will remind you of the accuracy of their prediction. If not, they assume you will forget.

Muddle Through Still On Track

There is lots of other data, like the new recent high in unemployment, to suggest that we will Muddle Through this year. Muddle Through may be the best we can hope for. Next week, we will look at much of the recent studies and take a fresh look at bonds. High yields were good to us last month, as my favorite high yield bond CGM posted some nice numbers. I will also report on what I learned at the recent SAAFTI (Society of Asset Allocators and Fund Timers, Inc.)

Mexico was relaxing, and I got letters from you saying how much you enjoyed Lynn Carpenter's letter. It is nice to be able to take a week off from writing and have someone so capable to stand in for me. I will admit to playing the Landmark Golf course on Sunday, where the play the Skins game. I now have a new appreciation for professional golfers. Those greens were difficult to read. How they can make birdies and pars consistently is beyond me.

One of the nice things about being in the money management business is that you get to meet so many interesting people. Last week in Southern Cal, while tiring, was made so pleasant because of getting to make so many new friends. Thanks to those of you who made my travels more enjoyable. Also, after dealing with Budget, I now understand why Hertz uses "Not Exactly" as their theme.

This is my anniversary weekend, so I am going to hit the send button and go home. Have a great week, and spend some extra time with family and friends. That is an investment which pays lots of valuable dividends.

Your glad to be back home analyst,

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