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Is Investing Starting to Get Difficult Again? I Hope So

So, what is investing again?

  • Equities should give a risk premium over bonds and cash in the long run due to a combination of what they mean for the issuer and what they mean for the buyer
  • It is not the idiosyncratic risk of an investment gone wrong that explains why stock investors should demand a decently sized risk premium. It is the correlated risk. Given the cyclical nature of the economy and the fact that corporate profits are the most volatile major constituents of GDP, most equities will tend to do badly at the same time
  • Equity losses will occur at just the time that is most painful for the entities that own them. And that is the key. A portfolio does not exist in isolation
  • At a time when the cost of equity is low both relative to history and the current return on capital, why have companies been issuing debt and buying back stock instead of issuing stock to raise capital? If corporations believe that downturns will be uncommon and mild, they will rationally respond by shifting their capital structure away from expensive but safe capital into cheaper and riskier capital (debt)
  • The “Great Moderation” had many investors convinced that economic downturns simply didn’t happen anymore. This led to the most extreme mispricing of risk that we’ve ever been able to see in financial market history
  • Since GFC, not only have fears of economic downturns receded again in the minds of investors, but it has seemed easier than ever to protect portfolios even should something bad occur
  • There is an asset that is likely to cushion the blow at that exact time – high quality bonds. Two important things tend to happen in depressions that are helpful to bonds:
    • Inflation tends to undershoot expectations as demand disappoints
    • Central banks generally ease monetary policy, lowering rates in real terms to stimulate the economy
  • The fact that bonds also tend to give a better return than cash helps explain why bonds are a mainstay of all but the most aggressive portfolios
  • High quality bonds did their job in the financial crisis. But what is more surprising is how astonishingly well they have done their job since then
  • Despite the fact that stock markets and bond markets have simultaneously rerated since 2009, the correlation between stock returns and bond returns has been more negative than at any time in history other than the Great Depression
    • The last decade has seen correlation dropping to -0.64, with the last five years a still stunningly low -0.55 despite the fact that no bad economic events have actually occurred
  • Free lunches shouldn’t persist in investing. They require counterparties to not only be irrational, but to also have a continual inflow of cash to replenish the economic losses that flow from their poor decisions
    • Low volatility and favorable correlations should not stably coexist with large ex-ante risk premia
    • This statement does not specify which state of the world we are in
  • Has risk fallen sustainably and risk premia fallen along with it? If so, you will need to lever up to try to earn the kinds of returns that unlevered portfolios used to deliver
  • Or has the recent “easy” environment been a temporary one that is bound to reverse?
  • Even if the natural volatility of the economy has fallen over time and even if policy response is better than it was 80 years ago, neither markets nor economics are all that well-behaved
    • Stability breeds instability
    • Statistically, we should expect to get periods of relative calm in any natural system, and those periods end
  • The calm itself encourages behaviors that eventually lead to highly volatile outcomes
  • The very existence of risk parity and volatility targeting strategies create fragility in the markets in the form of feedback loops
  • A period of calm will lead to increased leverage, which creates net buying to support markets. But a rise in volatility or shift in correlations can lead to deleveraging and selling pressure just when markets are already shaky

Beyond Purgatory and Hell

  • Scenarios of Hell and Purgatory – those two scenarios differ in the equilibrium level of cash rates, but assume that risk premia are largely unaffected
  • Equities have a lower required return in Hell because the alternative of holding cash or bonds has a lower return than it used to, but we still assume a 4-4.5% equity risk premium over cash and a 1-1.5% term premium for bonds over cash
  • The low volatility and negative correlation scenario is a different shift – a decrease in required risk premia due to the fact that diversified investment portfolios are less risky to investors
  • As with the Hell scenario, the “low risk” scenario makes for a rosier short-term outlook
  • Today’s valuations of US stocks and bonds can be decently explained by a combination of Hell, low volatility, and negative correlations
  • If inflation stays low and cash rates remain low and cooperative markets allow portfolio engineering to reduce the risk of stock/bond portfolios, you can make today’s valuations levels make sense
  • On our data, US stocks look priced to deliver something around 3-3.5% real if they stay at today’s levels forever. That’s perhaps a 3% risk premium over cash, assuming market estimates for cash rates are correct. Bonds are priced to deliver perhaps 0-0.5% above cash
    • Those are smaller risk premia than we have seen historically, too small in our minds if future correlations are positive again and true economic risk is in line with historical volatilities instead of recent ones
  • In 1Q18, the annualized volatility for the S&P 500 was 19% and the correlation between stocks and bonds was between -0.2 to 0.1. This is in contrast with the last 5 years, where the volatility of the S&P was under 8% and the correlation between stocks and bonds has been -0.55
  • After years of very low volatility and strongly negative correlations, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years
    • In that world, historically normal risk premia make a lot of sense, and all of our collective investment goals rely on those risk premia remaining similar to historical levels
  • Markets today, particularly US markets, aren’t priced for this world, so if current conditions persist, I believe valuations are likely to fall

GMO: Is Investing Starting to Get Difficult Again? I Hope So, 1Q18

Image Source: GMO

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