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Equity Returns With Bond-like Volatility

Equity Returns With Bond-like Volatility

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Published by mordenviabank
FEATURE
A WICKSELLIAN APPROACH TO ASSET ALLOCATION: EQUITY-LIKE RETURNS WITH BOND-LIKE VOLATILITY
By Thomas Aubrey, Founder of Credit Capital Advisory This article is taken from the forthcoming book ‘Profiting from Monetary Policy’ which will be published by Palgrave Macmillan. The book uses Datastream extensively to support the argument that the prevailing monetary policy consensus generates misleading signals, resulting in unexpected losses to investors. Building on the work of Wicksell, Hayek
FEATURE
A WICKSELLIAN APPROACH TO ASSET ALLOCATION: EQUITY-LIKE RETURNS WITH BOND-LIKE VOLATILITY
By Thomas Aubrey, Founder of Credit Capital Advisory This article is taken from the forthcoming book ‘Profiting from Monetary Policy’ which will be published by Palgrave Macmillan. The book uses Datastream extensively to support the argument that the prevailing monetary policy consensus generates misleading signals, resulting in unexpected losses to investors. Building on the work of Wicksell, Hayek

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Published by: mordenviabank on Jul 03, 2012
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A WICKSELLIAN APPROACHTO ASSET ALLOCATION:EQUITY-LIKE RETURNS WITHBOND-LIKE VOLATILITY
By Thomas Aubrey, Founder of Credit Capital Advisory
This article is taken from the forthcoming book ‘Profiting from Monetary Policy’ which will be publishedby Palgrave Macmillan. The book uses Datastream extensively to support the argument that theprevailing monetary policy consensus generates misleading signals, resulting in unexpected lossesto investors. Building on the work of Wicksell, Hayek and Myrdal, the book sets out an alternativesignalling framework for investors, generating equity-like returns with bond-like volatility.
Although the returns on equities in the long run have been superior to those on bonds, equity returnsremain extremely volatile due to the nature of the business cycle. Long-only investors attempting tominimise this volatility using indicators emanating from the current macroeconomic framework havefound this challenging. This is because the neo-classical framework is fundamentally flawed andgenerates misleading signals for investors. The post-crisis debate on reforming the financial system haslargely ignored the fact that the neo-classical synthesis, which underpins monetary policy, is unableto model credit effectively. However, using the credit-based framework of Wicksell, which was laterenhanced by Hayek and Myrdal, it is in fact possible to analyse the business cycle allowing investors toswitch out of equities before markets crash. This theory is based on the notion that differences betweenthe return on capital and the cost of capital drive profits. The expectation of future profits in turn drivesthe process of credit expansion and contraction, which explains the business cycle. Analysing theturning points of the business cycle thus allows investors to profit from a simple switching strategybetween equities and bonds.
Equities still outperform in the long run but not over the last decade
Equity investors, according to the Barclays Capital Equity Gilt Study, have done well in the long run.Between 1925 and 2011, investors in US equities would have generated real returns of 6.6% pa despitefive consecutive years of negative returns during the Great Depression. Bond investors would have faredless well with real returns of 2.6% pa. However, there is one main problem for equity investors, and thatis equity returns can be extremely volatile. For example, anyone who had the luck of retiring in 1999based on an equity portfolio started in 1960 would have generated returns of 7.7% pa, over 50% moreper annum than the person who retired in 2008, which generated returns of only 5.1% pa.
FEATURE
 
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Moreover, anyone who started saving for their retirement in 1999 and accepted the prevailing wisdomat the time that equities would maintain their upward trajectory, would have seen annualised lossesof 0.9% pa. However, those who disregarded the consensus and invested in government bonds wouldhave seen annualised returns of 6.6%. Although the evidence is reasonably compelling in the longrun to invest in equities, a ten-year period of negative returns on equities – which may be more than aquarter of the lifespan of an investment plan – is clearly a major issue for investors. Particularly giventhat when a person decides to start and stop saving for their retirement is partially out of their control.As of yet, however, there are few if any low-cost investment products that invest through the businesscycle, generating equity-style returns with substantially lower volatility.Today many investors use real GDP growth forecasts as a leading indicator of equity returns for assetallocation decisions which is problematic for a variety of reasons. Firstly, real GDP growth forecastsfailed to capture both the dotcom crash as well as the recent financial crisis. For those investorswho were in equities during both those periods, by the time real GDP forecasts had adjusted, themarket had already fallen, leading to substantial losses. This should perhaps not be surprising giventhat the leading theorists of the current macroeconomic paradigm have argued that events such asthe recent financial crisis cannot be predicted due to the inability of econometric models to identifystructural shifts. Furthermore, investors have been duped since the 1980s by central bankers, whohave consistently argued that as long as inflation remains subdued, an economy still has room to grow.The implication of the “spare capacity” argument is that the outlook for profits remains positive, thusasset prices ought to continue rising. The dotcom boom and recent US housing bubble both took placeagainst a backdrop of low inflation, as did the Japanese property and equity bubble of the mid-1980s.These bubbles were missed because the neo-classical synthesis largely ignores credit. It is, of course,an expansion of credit – that may or may not lead to rising inflation – which causes sharp increases andsubsequent falls in asset values.
Wicksell to the rescue?
One way of being able to construct such a low-cost fund that can generate equity-like returns withbond-like volatility, is to use a tactical asset allocation approach based on the credit theory of KnutWicksell. The investment process is based on a straightforward annualised switching strategy betweenequities and bonds on a country basis. If we take US data from 1986 to the present, an equity investorwould have generated annualised returns of 6.4% with bonds at 5.8% pa, so equities would still havebeen the better bet. However, the credit theory of Wicksell which was subsequently developed by Hayekand Myrdal – who jointly shared the 1974 Nobel Prize for Economics – does provide a great deal ofinsight into the trajectory of the profit rate and hence capital values. Indeed, investment triggers usingthis approach would have generated annualised returns of 8.2% with a lower volatility than that ofbonds. It is worth noting that these returns have been inflated due to the strong performance of thebond market over the last 20 years, which is unlikely to repeat itself in the next 20. However equity-likereturns with half the volatility are still an investment product with a great deal of value for consumers.So how does Wicksell’s theory signal to switch to bonds before equity markets crash in value, thusavoiding the downside of equity price movements and switch back into equities when the outlook forprofits improves? His theory is based on the notion that profits increase either due to an increase in thereturn on capital and/or a fall in the cost of capital. An improved outlook for profit growth stimulatescredit creation, which in turn becomes critical to sustaining future profit growth. The WicksellianDifferential, which is the difference between the return on capital and the cost of capital, is thus anindicator of equity values. (For a more detailed understanding of how the Wicksellian Differential iscalculated see Profiting from Monetary Policy, Infostream Q2 2011.) As shown in chart 1, the relationshipbetween real GDP growth and real equity returns is not particularly close except when output fallssuddenly, thus providing further evidence that using real GDP as a signal is unhelpful for active equityinvestors looking to minimise the volatility of returns. Indeed, econometric tests have shown there to belittle correlation between the two.Chart 1 also highlights two interesting periods of the Wicksellian Differential and actual real GDPgrowth. Firstly from 1996, as the tech bubble kicked off, the rate of profit growth began to decline,although real GDP growth and equities rose until they crashed, resulting in losses of trillions of dollars.
 
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Chart 1:US real GDP growth,real equity returns andWicksellian Differential
The calculation of the Wicksellian Differential is however an ex-post measure, so is unhelpful for investorsto use as an investment trigger, hence an ex-ante model needs to be constructed based on the underlyingdrivers of growth in the Wicksellian Differential, which is of course leverage. However, an ever-increasingamount of leverage is clearly unsustainable and will cause expectations to shift at some point, resulting ina period of deleveraging and falling profits. As a result, an investment trigger can be set up based on thedynamic relationship between leverage ratios and the rate of profit, which requires constant recalibrationas new data is made available.
Borrow, borrow, borrow… Default
Chart 2 shows three leverage ratios – consumer, corporate and government against the WicksellianDifferential highlighting the key drivers of rising and falling profits. The relationship between eachleverage ratio and the rate of profit is unique and dynamic through time. For example, the slowdownand fall in the consumer leverage ratio caused the Wicksellian Differential to reverse between 1990and 1992. Furthermore, during the tech bubble between 1996 and 1999, corporate leverage fellfollowed by consumer leverage, causing the rate of profit to fall. This highlights that there was no realbasis for rising equity returns during the tech bubble as the rate of profit growth was falling. Thus thedotcom bubble ought to be seen as akin to John Law’s South Sea bubble, which was purely based ona rather large misconception. The extent of the credit bubble leading up to the recent financial crisis ishighlighted by the substantial rise in consumer leverage, the rate of which began falling at the end of2006, highlighting the downturn in the rate of profit growth in 2007, and thus a shift to bonds. Finallyconsumer leverage rose again in 2009, signalling a recovery in profits, although the recovery wasshort-lived. In 2011 the trend fell again, and the 2012 signal highlights a continuing slowdown in theunderlying trend of profit growth.This is one of the reasons why the returns to this investment strategy are less volatile. The secondperiod was in 2004-2006, when the rate of profit growth was rising as were equities, despite real GDPgrowth being in decline. The rate of profit began to decline in 2007, thus indicating a switch to bonds,but allowing investors to capitalise on the increase in capital values between 2004 and 2006.

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