The Real Returns Report

Welcome
Welcome to the inaugural issue of the Real Returns Report! This project is borne of a few observations. This much is clear: Investors are, in their majority, looking at the wrong models and the wrong set of numbers this holds equally for the amateur and the professional. instruments has not been a great guide to nearterm or medium-term performance."1 Individuals have an excuse for looking at the wrong models they're not professionals. As for the professionals themselves, well...

[Jim Reid, by the way, is one of the restricted Take those who value the broad market using a number of professionals worth reading.] price-to-earnings multiple based on 1-year forward earnings-per-share (EPS) estimate, for If you can't join 'em, beat 'em example. It should be clear that the denominator Logically, I should be overjoyed that so many in that ratio is too volatile to enable us to say investors are looking at the wrong numbers. anything useful concerning Why would I want to alert whether one can buy a dollar of anybody to that fact if I might This much is clear: earnings on the cheap or be competing be against them? whether one should remain on Investors are, in their This project isn't an act of the sidelines. This is before we charity. My first goal is to even get into a discussion on the overwhelming produce data for myself -unreliability of 1-year forward that is relevant for assessing the estimates. majority, looking at the investment merits of different markets and asset classes. This End the Fed (model)! wrong models and the data is hard to find even in Another case in point is the Fed the U.S., which has arguably the model, according to which wrong set of numbers. most accurate and complete investors can weigh the relative sources of primary financial attractiveness of bonds versus data. Once you go hunting for it outside U.S. stocks by comparing the bond yields with stocks' borders, you really have your work cut out for earnings (or dividend) yield. With interest rates you. In most cases, it simply doesn't exist; I at historically low levels, it must seem like such know this because I've tried and it has brought an appealing yardstick particularly if one is in me to this point. the business of selling stocks. Alas, as Deutsche Bank's Jim Reid and Nick Burns wrote in the 2010 edition of their outstanding Long-term Asset Return Study: "[The graph of the US Earnings Yield versus 10Year Treasury yield] suggests to us that it's very difficult to find a consistent Equities vs. Fixed Income valuation relationship throughout history... Outside of this period [the mid 1960s to the mid-1990s], comparing the Earnings Yield (1/PE) with the yield on Fixed Income If I share some of the results of my work, it's for a very specific reason. I am a strong believer in collaboration; my hope and ambition is that I will receive feedback from readers that will enable me to sharpen or extend my analysis. Here's what you can expect Let me briefly outline the scope of my enterprise. Here is what I mean to provide on a weekly basis:
1

LT Asset Return Study: From the Golden to the Grey Age, Deutsche Bank, Sep. 10, 2010.

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Updates of the valuation models and return forecasts for the markets I'll be covering (I'm starting with the U.S. stock market, but I'll be adding foreign markets fairly rapidly. It's also my intention to add other asset classes over time.) Commentary on some theme relating to financial markets. I might look at a current event or discuss what I think is a significant change in model outputs (I realize this is a bit vague, but I'm going to go ahead and leave myself quite a bit of leeway here.) I'll make available some of the data I use to calculate the valuation indicators. I may, from time to time, publish excerpts of conversations with first-rate analysts, investors and commentators.

Law of Large Numbers takes over and it is virtually inescapable, barring an extraordinary shift in market regime. Third, outside of highly unusual instances of arbitrage, there are no certainties to be had in investing -- very few people will agree to take the other side of a certainty. Recognize that this is a game of odds and that your goals should be: First, to remain in the game, i.e., don't go "all in." There are no points for showmanship at this table and if you lose all your chips, you'll need more than an invitation to play in the next tournament. Second, look for bets on which you are being well paid to take on risk. Finally, make sure you're in a position to capitalize when those bets come around. This may seem completely uncontroversial, obvious, even. I can't disagree, but my experience of observing pundits and investors in their natural habitat suggests it all goes right out the window come game time. That's exactly what I aim to avoid; looking at relevant data on an impassionate basis is one's best hope of navigating the menacing seas that are today's markets. Discipline and rationality are my fundamental building blocks; I'm ready to start the build. If I'm fortunate, some of you will contribute a stone (or more) along the way.

3 Things I've learned As far as my investing orientation goes, I'll summarize my experience and observations in three points: First, valuation matters hugely! In fact, understanding valuation is investors' best opportunity for earnings excess returns (much better, certainly, than trying to guess what Apple's earnings will be next quarter.)

Second, mean-reversion is a reality in financial markets and at the index/ asset-class level, the ____________________

Commentary: Not Cheap Enough!

The two best indicators of long-term stock market value, the equity q ratio [see the notes below fig. 2] and the PE10 (Shiller's cyclicallyadjusted price-to-earnings ratio) aren't entirely in agreement right now. If we're to believe the former, the S&P 500 is roughly fairly valued right now, with a q ratio of 0.74 barely above its long-term historical average (see fig. 1.) The PE10, on the other hand suggests a fairly significant overvaluation, with a premium to fair value of 30% - 40%. I'd suggest that reality lies somewhere in between and that the market remains at least modestly overpriced right now. Either way, there is no evidence that it is a wonderful bargain, which seems to be a common refrain (or as one former Goldman partner used to tell trainees: "In the securities industry, there's only one way to be -- and that's bullish! Always bullish!) Don't' misunderstand me: There are pockets of decent value within the market, but one has to perform sell-side-level mental acrobatics to describe the broad market as 'cheap'. If an indicator is to be of any use whatsoever, it should have at least some predictive power Page | 2

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regarding expected returns for any given stock market level. Both the q ratio and the PE10 have passed these tests repeatedly. Looking at the distribution of 10-year returns conditional on the starting value of the q ratio (see fig. 2), and focusing specifically on the .70.90 bucket (the current q value is .74), we obtain a nice, even distribution of returns centered at roughly 2.5% annualized (inflation-adjusted.) Given the volatility of returns around that figure the annualized loss exceeded 5% one-fifth of the time those numbers don't support the notion that investors are being fairly compensated for bearing equity-market risk. Admittedly, .74 is the low end of our bucket; if the ratio were to move into the next range down (.50-.70), the distribution of returns begins to look much more attractive, as the frequency of loss becomes more palatable. On that basis, I'd estimate 10-year stock market returns in a range of 1%-5% per annum. Historically, stocks have produced an annualized return of 6%-7%, that figure is therefore inadequate to justify a full position in U.S. equities. I'm reasoning here at the level of the S&P 500 index. If you happen to be a gifted stock-picker, carrying an overweight position in stocks may pose no issue at all. In the current environment, even if we expected stocks to generate a return consistent with historical experience, prudence dictates that we require a margin of safety. The extraordinary macro-economic headwinds that result from the Great De-Leveraging should not be ignored. As Carmen Reinhart and Ken Rogoff demonstrated in This Time is Different: Eight Centuries of Financial Folly, these headwinds are also part of the historical record. While the U.S. stock market don't look like a disastrous investment at current prices, I'm convinced there are more attractive destinations. I expect to identify some of them in the weeks and months to come. Next week: Look for some explanation/ discussion of the valuation indicators I use and if my schedule complies, I'll add small-cap stocks to my tables. Page | 3

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Fig. 1 - Valuation indicators for U.S. stocks (Broad market/ Large-caps), January 20, 2012
% Above (below) geometric mean % Above (below) arithmetic mean

Current value (01/21) Equity q ratio, Aggregate U.S. equities Equity q ratio, S&P 500 P/E10, S&P 500

Series length

Percentile rank

Standard deviation

0.82

1945 2011

50%

23%

(7%)

0.26

0.74 21.4

1871 2011 1871 2011

45% 82%

2% 40%

(7%) 30%

0.31 6.6

Source: Federal Reserve Board of Governors, Robert Shiller, Standard & Poor's, Aleph-one

Fig. 2 - Distribution of following 10-year real stock returns (ann.) conditional on the equity q ratio
< (5%) <.50 Equity q ratio .50 - .70 .70 - .90 .90 - 1.10 >1.10 0% 3% 21% 6% 3% (5%) - 0% 3% 14% 21% 22% 13% 0% - 5% 11% 24% 12% 37% 36% 5% - 10% 27% 24% 25% 21% 41% >10% 59% 34% 22% 15% 8%

Source: Robert Shiller, Standard & Poor's, Aleph-one

Notes Equity q = Market value / Net worth (estimated at market prices) This is a variation on Tobin's q. When it is calculated over all U.S. equities, it is a quarterly series since it depends on data from the Federal Reserve's Flow of Funds report. However, it's possible to calculate the ratio mid-quarter, as I have done, by adjusting the market value to reflect changes in equity market indexes. I used the Wilshire 5000, which is the broadest measure of U.S. equities' market capitalization and performance. PE10: Also known as the cyclically-adjusted PE (CAPE) or the "Shiller PE" after Robert Shiller of Yale. The PE10 uses the average of the prior ten years' earnings, on an inflation adjusted basis, as its earnings input. The rationale behind this is the observation that earnings are too volatile on a year-to-year basis to provide reliable information on a company's (or a market's) true earnings power. By using a ten-year average, the PE10 smoothes out earnings volatility and allows investors to better identify legitimate changes in risk premiums. The figures in this table are derived from Professor Shiller's data (available from his web page), series of monthly average prices for the S&P 500/ S&P Composite Index.

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Fig. 3 Current trailing returns in historical context

Current value (01/20) Trailing 5-year real return (ann.) Trailing 10-year real return (ann.)

Series length

Percentile rank

Geometric mean

Arithmetic mean

Standard deviation

(2.0%)

1871-2011

15%

6.8%

6.0%

7.5%

2.0%

1871-2011

21%

6.3%

6.2%

5.0%

Source: Robert Shiller, Standard & Poor's, Aleph-one. Returns distribution parameters calculated based on the monthly return series

This research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. This research does not constitute a personal recommendation. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.

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From the Archives

Currier & Ives of New York, self-described 'Publishers of Cheap and Popular Prints' produced this lithograph titled 'The way to grow poor, the way to grow rich' in 1875. The ways to grow poor enumerated in the lefthand panel are, from left to right, top to bottom: Rag money, games of chance, betting, gift enterprises, capital prize $100,000, inflation, grand prize $100,000, policy, public office, jockeying, rings, puts & calls, pools (i.e. stock pools), the credit system, "something for nothing", a lucky hit, gambling, fancy stocks, railroad bubble, a big bonanza, lottery, speculation, bogus scheme and gold mine bubble. Meanwhile, the sober, industrious citizens in the right-hand panel are a fine example of a sound Protestant work ethic. How serene they look

next to the frenzied crowd chasing bubbles and scams. It is clear from their bearing that no-one has yet told them that their crafts will be soon be outsourced to machines.

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This research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. This research does not constitute a personal recommendation. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.

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