Indexing Bubble and Asset Class Returns Still Revert to the Mean
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Walking the money for the rest of us. This is a personal finance show on money, how IT works, how to invest IT and how to live without worrying about IT and your host David stein today is episode five o four, its title indexing bubbles and asset class returns still revert to the mean. This is part three of what has turned out to be a three part series, primarily on the U.

S. Stock market, which is add its most expensive level relative to non us. Stocks of all time.

We have looked at U. S. Stocks back in episode five hundred and last we can, episode five o three.

We've pointed out how the U. S. Stock market makes up sixty six percent of the global stock market, even though the U.

S. Economic output, or GDP, is only twenty six percent of the world's economic output. We've done performance attribution where we've looked at the impact of valuation changes on U.

S. Stock market out performance, where four percent age points of the close to thirteen percent analyzed. Return for U. S.

Stocks over the past decade is because stocks have gotten more expensive, will share a paper by rob or not, where he uses the phrase that called evaluation performance that driven by an asset class getting more expensive or less expensive. We've looked at positive pants that contributed to a stock market. Our performance such as U.

S. Is deep and attractive financial markets, the nation's venture capital availability for startups, the higher education system that attracts top talent from the around the world. We've looked at some maceo omy tors that have contributed to the outperformance, such as the growing U.

S. Federal budget deficit, with those elevated cash flows flowing into the economy boosting corporate profitability. We've also looked at the earnings overlap, how forty percent of earnings of stocks that comprise the M P five hundred index come from non U.

S. Countries, wherein U. S. Listed companies, those stocks over get twenty percent of their earnings from the united states.

We've looked at golbin sex for cash that us talks will return. Only three percent analyzed over the next decade, with a range between negative one percent and seven percent. Now I have more to say about this as I continue to think about the U.

S. Stock market, how incredibly successful IT has been over the past fifteen years. Or an investor since two thousand and nine would have earned eleven times their investment a thousand percent return since march two thousand nine. There's a phrase though, in ance, in other statistical fields called reversion to the mean IT means that extreme outcomes tend to move back toward its average is higher than every journey growth, higher than average returns, higher than average dividends als or lower than average returns, lower than average earnings growth, lower than average dividends.

When IT relates to stocks will look at some examples of reversion to the mean that, yes, IT does apply to asset classes also in the subway going to look at the impact of passive investing or indexing, which has become an even larger part of stock market sting and IT has had an impact on U. S. Stock markets over valuation.

And so we will look at, well, how could that end? A key element of this week's episode is an article by Robert, are not founder of research affiliates or not, is seventy years old now? He has been highly influences, along with south korea, in the hedge fund manager.

In my approach to investing, Robert not wrote a blurb for my book, money for the rest of us, ten questions to masters success investing. He called IT up a clear road map for investors. He contributed a series of articles in the journal of purta lio management.

The journal portfolio management is my favorite financial academic journal. Back when I was in graduate school, I I would just go to the library and sit and parse finance journal. I was a financed erd, and that journal has been very influential in how I invest.

And so it's celebrating its fifteen th anniversary and robber not contributed. Article title the equity risk premium nine meth. The equity risk premium is a measure of how much stuff are expected to outperform bonds.

And traditionally, it's thought that stocks shoot out, perform bonds by five percent. That's one of the mithers that will look at are not points out so that this equity risk premium only works. Looking forward, how stocks have performed relative to bids going backward is not a risk premium.

A risk premium is expected excess return you get for taking on risk. And in the paper link to the papers I share in the show notes, they go back two hundred and twenty two years of stock and bond data back eighteen o two, and they show walling ten year stock and bond market returns. And the range was incredibly why there were ten year periods where stocks outperformed bonds by nineteen percent of the points.

And there were periods, a ten year periods where stocks under perform bonds by thirteen percentage points analyzed now are not right. For most of us. Ten years is a reasonably long investment horizon, yet few would consider a nineteen percent annual risk premium reasonable, and no one would consider a negative thirty percent rise.

I'm reasonable. And so when we think about what stocks should earn relative to bond going forward, we need a basis to determine that. And one of the myth are not.

Addresses in this paper is long horizons and forecasts are hard. We got into a discussion on the bogo head form where they went back and forth in. A number of participants in that form are convinced one cannot forecast long term stock returns or bond returns.

And I, via amenti, disagree with that. I have forecasts the long term returns my entire career. And where I got the Price this was from, rob or not, and research a pilot is he write, any asset or market will produce returns in three ways, income, such as a divide or bond coupon.

The growth in income, which would be zero for bonds, intially negative, a junk bond due to the fault. T could be earnings growth in terms of stocks. That's the second element, the growth and income.

And the third is changes in valuation multiples or stocks, or spread the incremental yield promote. Five years ago and I released my book, we went through the math of how that works, and it's what I have taught consistently on money for the rest of us. And our stock and bond market index research to asia camp is completely based on that, are the expecting return models we use are based on those three elements.

The performance attribution that we show for stocks is based on what was the income, what was the income growth and how evaluations changed or not, says the current income. The first component, if we're forecasting, expect or returns the equity risk premium, the additional return of stocks of response, the first component income, he says, is usually easy forecast. It's the yield, it's the dividend yield on stocks, the percent of profits paid out, the shareholders divided by the Price, it's the the yield, the interest yield on the bonds.

And so when we're forecasting the expected return of investment great bonds, for example, the best forecast is the starting yellow maturity. If your forecast period is ten years or more, that's how we've come up with expected return assumptions on money for the rest of us. Plus and on acid camp, how research fillets does IT in their acid allocation tools that they make available because that tell the math works, that simple can be done the in the second component total more chAllenging for bit easy because the income doesn't grow in terms of the interest rate isn't growing over time.

It's it's static. So you use the starting ultimatum ity for stocks, use earnings pressure growth and that can be impacted by the growth in the economy as well as share buybacks. The third component is the change in valuations and are not rights most as classes ten towards mean reversion in valuation multiples or spreads.

And the third component, basically that means evaluations are exceedingly high for stocks or the incremental yield for non investment grade bonds are exceedingly narrow. They return to the average at some point. Markets move in cycles, and it's paramount that we understand those cycles. So we set reasonable expectations for asic class returns in the paper.

Looking at at two hundred and twenty year history that are not, did he pointed out that there is a correlation, a relationship that's negative between prior ten year real stock returns and the next ten year period? In other words, when the ten year return was above average, the next ten years, because I was negative, correlated was much lower than that, he write. When stocks offered a terrific real return to one decade, they tend to reverse course over the next decade and vice versa.

This correlation is both statistically significant and economically meaningful. We can ignore IT stocks, returns, move and cycles because of those three underlying element. He reference some data from epson that real earnings s have a negative fifty five percent correlation.

So in a decade where earnings per share growth is meaningful ly above average, the next decade is below average. On as a camp, we show a chart for and choose anyone of forty six stock indexes, and we show five year historical earnings pressure, red growth for the U. S.

Stock market that average five year earnings per share growth is six point seven percent. And then on there, there's a blue line that shows five year earning per and IT goes up and down, sometimes above the average. Then IT goes down a tends to be five year periods where the the peak is flowed by a trough that occurs about five years later.

There is reversion to the mean and we can't fall into the trap. As he points out, the industry did back in two thousand, assuming that excEllent past returns were predictive of future above average h returns because they're not because of this, reversion to the mean are not right. If a stock doubles in Price and its underlying fundamental are unchanged, no sensible investor would expect that these past returns are useful prediction of future returns.

Indeed, unless the fundamental subsequently catch up to the Price, strong past returns may passage weak future return. And what applies to individual stock also applies to asset classes are not mentioned. Back in year two thousand and I I was an institutional investment advisor we were doing asset class assumptions typically would update once year, and I could not find in my records what we were forecasting for the ten year return from between two thousand and twenty ten at my old firm method.

Advices are not points out that the average corporate pension fund use an all time high return expectation for a baLances portfolio about sixty percent stocks, forty percent bonds of nine and a half percent that was the forecast, which means with boniest six percent, that was a reasonable forecast for bonds since that was the starting in the maturity. But IT implies a twelve percent return from the year two thousand and twenty ten for stocks at time when that first element, the income, the divided yelled was one point one percent, which means. Stocks earnings growth would have to be double digits over the next decade for U.

S. Stock to return twelve percent, or if earnings came in less than double digits than the stock valuations would have to get more expensive at the time the trAiling twelve month Price to earning to asia for your stocks was thirty one. Incredibly expensive pension plans, no doubt assisted by their investment consultation, which we were one, which is why I wish I had our tenure forecasts.

I just don't, but they were forecasting twelve percent U. S. Stock returns in the early part of two thousand.

What did U. S. Stocks return over the next decade? Negative one and a half percent.

Analyst, the dividin iod, as I mention, was one point one percent at the beginning. At the decade. IT was one point nine percent divided.

Iod, at the end of the decade. So dividends contributed one in a hf return. The earnin's per share growth was IT even closed the double digits, two point one percent earnings per share growth analyzed over that decade. So combined, the return would have been just over three percent analyzed, far short of the twelve percent forecast.

But the returns are actually negative, negative one and a hf percent, which means there was a revaluation downward that cost five percent per year because the Price to earning to ratio went from thirty one down to ninety. There is reversion to the mean. We can't simply naively assume what happened in the past, especially the recent past, will continue.

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He includes a chart showing the seller earnings yelled and earnings yield is the earnings divided by the Price, is the inverse of the Price earnings ratio, and the shiller earnings yield is also called the critically adjusted earnings yield. And instead of the earnings component being the most recent twelve months, earnings per share is inflation just the earnings over the previous decade? So they have this chart going back to nineteen twenty six, showing the earnings yield in the blue line and then the subsequent ten year stock market return.

And the two lines track each other in periods when the earnings yield is high, and the higher the earnings yield, the more tracking evaluation. The next ten years, the returns were high and when the earnings yield was low, the next ten year returns low. We can model this out in asia, cam, because we include long term, specifically adJusting or shaler PS and shelter earnings in yield.

So I thought, k, let me go ahead. Do that for the U. S. Market and world X, U, S, market.

First, I took a period where the earnings showed was very high for U. S. Stock market. The earnings al was eight point seven percent in february two thousand nine, one standard deviation cheaper than average.

And the world X U, S, earning yield in february two thousand nine was nine point one percent, almost two standard deviations cheaper than average. And what were the returns? The U.

S. Stock market return fifteen point nine percent. analyze. And world actually U. S. Return nine and a nine percent, so above average.

If we look at a period where the earnings yield was very low, november two thousand world X, U, S, earnings iee was three point two percent. U S, earnings yield was the same as IT is today around two point eight percent. And what was the ten year return going from two thousand? The twenty ten we already shared some of that U S.

Talk marker return point two six percent analyzed over that slightly later period. Where's world x us. Return below average of three, nine, nine percent? There is relationship between the starting valuation, this case earnings yield, and the subsequent return.

We can ignore that there is reversion to the mean are not points out, there is overwhelming global evidence of a strong link between starting divided yield and the subsequent real return for stocks and the access return for stocks relative bonds when divided yids are higher, the stock returns are higher over the next decade because again, forecasting future return. So I ask a camp if I sorted the forty six stock indexes by dividend yield to figure out which stock index has the highest divided yield relative to its long term average. And the most attractive right now is world X U.

S. Small cap value, four point three percent divided yield. The long term average for that sector is three point two percent, is one and a half standard deviations above average that suggest world X A smoke value will perform above average over the next decade, especially when we look at some of the other elements, such as is its earnings yield is also more attractive than ever right now.

There is reversion to the mean, and there's also evaluation how something gets more expensive over time can impact returns. And that points one of the miss are not shows, is that the myths, history shows that the equity risk premium is about five percent, that stocks, on average, to return five percent more than bonds. But they also point out over a ninety eight year history that stocks have gotten more expensive.

And if stocks hadn't gotten more expensive, the access return for stock's relative to bonds would have been three point two percent rather than four and eight percent to five. So a long term stocks getting more expensive contributed to that five percent average access return. Now our period were divided in yellow are one point two percent, the average dividend yell of U.

S. Stocks are the past ninety years was three point eight percent, but higher dividend year contributed to the five percent. Access return for stocks. Sponsor now divided are much lower, valuations are much higher, and starting yet maturity for bonds are much higher.

That's why, and I don't have the exact statistics, but golden sex predicted that there was a meaningful probability IT was, I believe, around thirty percent that U. S. Stocks could under perform treasure over the next decade. And golden sexes is using the same inputs.

What's what are the dividend yields? What's the the old mature water valuations? A final myth, rob or not points out, is if your investment horizon on is twenty years, you almost can't lose with stocks back in. Earlier, this cheered up to four sixty eight IT was titled lessons from japan's thirty four years of stock market under performance.

IT took thirty four years for japanese investors to get back to the all time high for one thousand nine hundred eighty nine are not in his paper showed even lengthier periods where stocks on a Price basis didn't appreciate and there even longer pards seventy five years from eighteen or two, eighteen seventy seven, no real Price appreciation, and stocks, ninety seven years from eighteen thirty five to one thousand and thirty two, no real Price appreciation in stocks from nineteen twenty nine to one thousand nine hundred eighty six, fifty seven years, no real Price appreciation and stocks. And for the seventy six years for one thousand nine hundred six, two thousand nine hundred eighty two, now granted, a took a period where stocks were expensive, and I reached the second high, and then they took a period where they reached A A low or cheaper, a beginning point point. But you can not make money in stocks, native inflation, for long before the time, which is why we have to understand the underlying drivers and where we now or not, right? Just stock should earn with a meaningful real return and a risk premium relative to bonds and cash.

No, we are not all assure that they will do so in any given ten year, twenty years or even considerably longer span. We call IT a risk premium for a reason. Stocks are expected earn more than bonds because they are more risk y, but they're not guaranteed to.

And in periods like today, when divided, yields are very low for U. S. Dogs at one point one percent, valuations are very high with a trAiling twelve month P, E ratio of over twenty eight, and earnings growth has been well above average the past five to ten years.

Reversion to the mean says that could reverse in us stocks, could potentially under perform non us stocks and maybe even U. S. Bonds over the next decade, one more month.

And this once a little controversial. The myth is stock market earnings grow roughly as fast as GDP in the very long run. And they go back to eighteen o two and they show real GDP how faster grows.

And then they show that the real stock Price. Didn't keep up. The real earnings didn't keep up. The real dividends didn't keep up, and the per capital GDP output per person didn't keep up to economic growth yet.

He also points out their periods where earnings per share growth does keep up because of stock buybacks are not found statistically because new companies are being formed all the time, that they basically get allocated some of the profits in the economy. And so publicly traded stocks, earnings per share doesn't keep up with economic growth, except if the number shares outstanding is being reduced through buybacks. And that has been the case.

So I went back to asset camp and win and calculated the earnings per share growth going back fifty three years to the end, one hundred and sixty nine, beginning of nineteen seventy. And over that time, U. S.

nomo. GDP. Growth was six point four percent. World X, U, S, Normal earnings growth with six point three percent, the same rate as the economy.

And U. S, noral. Earnings growth was six point six percent, slightly faster. And so I think it's okay to assume that earnings, if there's going to be buy backs, can keep up earning pressure, can keep up with economic growth. But with higher bond interest rates, as companies borrow money, there is a limit how much they can borrow to buy backstop because you can also funded out of profit.

But the point is, again, that second element, what will the earnings pressure growth be? There's some way there is not as easy to forecast as the starting even in the ois, we use this building blocks approach of the income the income growth and change in valuation in terms the stock market expected return model and the bond market expected return model on acid camp. And you can stress test the assumptions to come up with reasonable returns on money for the restless.

Plus, we update those assumptions once a year for stocks, for binds and other asset classes, and those feed into our spread sheet. So you can categorize, expect, return of your portfolio, including all the asset classes. But we use the same building.

Blacks that are not at the team of research filet have used her decades. It's the approach I used as an institutional investment advisor. And IT makes sense, and IT keeps us from just saying what history will repeat because history does not.

There's reversion to the mean. After doing last week cept to email from a listener that wanted to know about the impact of passive investing the the number of four one k investors that each month just the four one k contribution goes into an S P. Five hundred index fun.

Does he rise a pass of investing? Is that impacting the outperformance of U. S. Stocks in? The answer is yes.

Back in one hundred and ninety three pass of funds made up only three percent of the stock market, active and passive. Now it's fifty three percent. It's a big component and a link to a couple of of academic papers.

And they point out a number of impacts of of the rise of indexing. One, the the stocks not included in the index there are less liquid because there's just less trading and IT compared to those that are part of the index. Second, when a news stock is added to an index, IT tends to pop in Price, while the stocks that are were limited from the the next fAllen Price.

The third, and this was a paper released this year, is that passive investing indexing biases the stock market towards aviation. As more investors possible index, the stock market gets more expensive. And we've seen that.

In addition, as more people index, diversification doesn't work as well because the stocks tend to co move because are being driven by passive investing, which is market risk. There's less indexing in on U. S.

dog. So less pass investing. And so there's been less of a valuation bubble there.

So how does that end? U. S. Makes up sixty five percent of the global stock market.

If those make a cap, stocks keep getting more, more expensive. The U. S. Stock market become a higher and higher percent, will get to be ninety percent, we don't know.

But how have other bubbles? And I live through and invested through advice clients, through the stock market bubble of two thousand. And we pounded the table and ensure our clients to diversify away from U.

S. A. Growth stocks, to value stocks, to equity reach, to nine U. S. Stock, to small cap, to merging markets.

Some did, and they benefit from IT because the internet burst and we had ten years of under performance. Asset classes revert to the mean this time around. IT could be disappointed with A I IT could be a fiscal crisis in U.

S. IT could be accelerated trade war. We don't know how long this current cycle or less now where valuations return to the long term marriage, probably not.

But when valuations went from A P E of thirty one down to nineteen and then A P E of nineteen is still above average for U. S. Stocks of the long term, that cost five percent of points per year.

We live to the housing bubble. The consensus was you can't lose money with the house. Yes, you can.

If houses get too expensive relative to rent, please consider in your purfoy lio. Don't naively invest in U. S.

stocks. Taking the exceptional returns over the past fifteen years can and will continue indefinitely. Markets move in cycles.

That's why we globally diversify into multiple different asset classes. That why I use an asic garden. We have exposed U. S. stocks. But IT shouldn't be our entire portfolio because of the sick ality of asset class returns and reversion to the mean. IT hasn't gone away despite the rise of indexing impassive investment.

Just a quick word you can give as a camp, these stock bomar research schools, three, seven day trial, plus we do a monthly webinar for as a camp users. Please give me a try and look at the data yourself to see how stock and bond market returns have been, what the current valuations is and the multiple tools we have there, so you can make informed investment decisions. Can learn more at asia camp dot com, that episode five, four.

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