Written by Rob Perrone, Investment Specialist, Orbis Investments
Growth and passive strategies have enjoyed a long day in the sun, generating great returns, but investors have grown too complacent about them.
Starting valuations for equities are high and the potential for persistent inflation upends the investing environment of the last decade. Investors can prepare for the coming sunset by getting actually diversified, across economic exposures and across styles within equities.
The last decade was a fabulous time to own financial assets. Globalisation thrived and worker power waned, allowing higher corporate profits, a boon to owners of equities. A rush of capital chased gushers of shale oil and gas, flooding the global economy with cheap fuel. And as the West recoiled from shows of military muscle, governments diverted funds from defence to domestic uses.
Crucially, those forces also reduced inflation. With inflation a fading memory, central banks felt safe in cutting interest rates at any hint of economic or financial pain. Low inflation, subterranean interest rates, and central bank bond purchases all pushed bond yields to the lowest levels in recorded history. Record-low bond yields meant record-high bond prices, and a rewarding ride for those invested along the way. Low bond yields also lowered the returns required from equities, pushing investors towards stockmarkets, so equity valuations swelled as well and valuations of exciting growth businesses, ballooned the most. With bond yields falling in response to every economic wobble, stocks and bonds enjoyed a happy marriage. Over short periods, bonds reliably counterbalanced stocks. Over the full period, they both went up. A lot.
Investors in a passive 60/40 mix of US stocks and bonds, reaped near-9% p.a. real returns for much of the last decade. An investor who bought that mix in August 2011 would have seen their purchasing power more than double over the next ten years. That is a high return. On average over the very long term, 60/40 investors have earned a still-good 5% p.a. after inflation. Figure 1 shows that such high returns are rare. The only luckier investors were those that set aside money for ten years in 1919, 1949, 1980, or 1990 — because those ten-year periods ended at the peaks of major stockmarket bubbles.
Chart: The 60/40 has generated excellent real returns recently – but not always
Focusing just on stock markets makes this pattern even clearer. As shown below, an investor in 2011 received an 11% p.a. real return on global equities for the next ten years. Their purchasing power nearly tripled. But long periods of great returns tend to give way to long periods of poor returns.
Chart: Periods of great returns tend to be followed by periods of poor returns
On the other side of the 60/40 portfolio, bond yields are more reasonable than they were a few years ago, but they are not high by historical standards.
Valuations drive long-term returns
Valuations may be a poor predictor of short-term returns, but they always matter for both equities and bonds.
On R-squared, a statistical measure that captures how much variation in one series is “explained” by another, starting equity valuations “explain” the bulk of variation in subsequent long-term returns. From today’s starting point, passive investors in global equities could expect a return as low as zero for the next ten years – before inflation. That does not bode well for the bulk of traditional 60/40 portfolios.
The link is even tighter for bonds, which makes perfect sense – if you buy a 10-year bond yielding 3% p.a. to maturity, and you hold it to maturity, your return will be exactly 3% p.a. For global government bonds, starting yields “explain” 93% of subsequent returns. From today’s starting yields, returns of 3% p.a. look all but baked in for long-term holders. Again, that’s before inflation.
Taking a long view of historical valuations, we find it hard to be enthusiastic about the returns of passive stock and bond market exposure. With equities priced to deliver poor returns, and bond yields at only 3%, traditional 60/40 portfolios look challenged.
Having enjoyed a long day in the sun, we believe that broad stock markets are expensive, which is bad news for passive strategies. And within equities, growth stocks remain exceptionally expensive. In addition, bond yields are not high, hurting the prospective returns of passive bond funds as well as traditional 60/40 portfolios. Periods of great returns historically give way to periods of poor returns, and those returns are poorest when starting valuations are expensive. They are expensive today, and in the next chapter, we will see the risks of being concentrated in expensive assets.
