© THOMSON REUTERS 2012
2ND QUARTER 2012
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.