Thursday, May 25, 2017

Yes. Demographics and Economic Growth Matter for Equity Returns

Quick note... for those not already listening, my buddy Patrick O’Shaughnessy has one of the (if not the) best investing podcasts out there with his podcast Invest Like the Best. Each week he sits down with some of the best capital allocators, investment thinkers, etc... in the world and really allows his guests to share deep insights. I highly recommend it to anyone reading this who isn't already doing so.

"Real GDP Growth Doesn't Matter for Equity Returns" is Wrong 

Patrick's guest this week was David Salem, the founding president and CIO for The Investment Fund for Foundations. The discussion was great as always, but I would like to focus on one small aspect related to where in the world he currently finds value. He specifically makes the case for Asia ex-Japan ex-China for a number of reasons I agree with (value and alignment of management with shareholders), but he seemingly gets one aspect (which he views as a negative) wrong based on his view of what historical analysis reveals. The point of this post is to outline this flaw with supporting data because it's a common theory and one that can seemingly be dismissed when the data itself is viewed. It also happens to makes his case for an allocation to Asia ex-Japan ex-China even stronger.

First to David (bold mine):
We also have some money allocated under present conditions to I’ll call it Asia ex-Japan ex-China. Here’s where a careful study of long-term capital market history will tell you, and my favorite source of this is of course is Elroy Dimson, Paul Marsh, and Mike Staunton’s book Triumph of the Optimist and all the sequels to it, will tell you that high growth economies that are flattered by relatively high growth rates of the GDP level and by favorable demography tend to generate surprisingly, perhaps to many people, sub-par returns. So. You’re a value guy, I’m a value guy. We get that. 
So, why would we be chasing return for long-term capital in Asia ex-Japan and even ex-China, and it’s because I’d say almost notwithstanding the favorable demographics and the relatively favorable debt profile the prices, the current prices at which interest can be acquired in well managed businesses where the managements have a sufficient, not perfect, but sufficient alignment of interest with outside shareholders, they tend to be family controlled and family dominated.
To summarize… he has found value in Asia ex-Japan ex-China DESPITE its favorable growth and demographics. To be blunt… this appears to be a common mistake and one that is likely flat out wrong. Here are other heavy hitters quoting Dimon, Marsh, and Staunton making the same case.

The Financial Times, Rising GDP not always a boon for equities (bold mine):
Analysis by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School of 19 major countries between 1900 and 2011 shows that the correlation between the compound real rate of return on equities and the compound growth rate of real per capita GDP is minus 0.39. Investors would have been best off investing in the most sluggish economies.  
Similar analysis of 15 major emerging markets between 1988 and 2011 produces a remarkably similar negative correlation of minus 0.41. To be fair, some other combinations produce correlations nearer to zero. 
But, to the chagrin of emerging market bulls, whichever way the data are interrogated, a meaningful positive correlation between GDP growth and equity returns remains elusive.

The Economist, A Puzzling Discrepancy:
The annual report on markets by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School (produced in association with Credit Suisse) is always good value and this year's effort is no exception. The main theme is related to emerging markets and will be the focus of this week's column. But one oddity emerged in the course of the report that is quite difficult to explain and is worth exploring in more detail. 
An oft-quoted argument for investing in emerging markets is their superior economic growth. But the professors have pointed out in the past that economic growth and equity returns are not correlated at all. 
This Economist article was in reference to the 2014 Credit Suisse Yearbook (which contains all the pertinent data) and is fortunately still available online. Let's take a look. The data for the following charts were all pulled from Table 1 in the pdf (reproduced below for any of you nerds that wants easy access).

Decomposition of Real GDP Growth and Economic Returns (1900-2013)

Real GDP Population Growth Per Capita Real GDP Real Return on Equities
Canada 3.63% 1.65% 1.95% 5.75%
Australia 3.35% 1.61% 1.71% 7.37%
USA 3.29% 1.27% 1.99% 6.45%
South Africa 3.20% 2.08% 1.10% 7.39%
New Zealand 2.89% 1.53% 1.34% 6.01%
Mean 3.27% 1.63% 1.62% 6.59%
Ireland 2.83% 0.05% 2.77% 4.09%
Portugal 2.70% 0.61% 2.08% 3.66%
Sweden 2.70% 0.54% 2.15% 5.77%
Spain 2.66% 0.82% 1.82% 3.62%
Switzerland 2.16% 0.80% 1.36% 4.41%
Mean 2.61% 0.56% 2.04% 4.31%
Japan 3.68% 0.94% 2.71% 4.11%
Norway 3.19% 0.70% 2.47% 4.26%
Finland 3.04% 0.63% 2.39% 5.31%
Netherlands 2.83% 1.06% 1.75% 4.95%
Italy 2.71% 0.53% 2.17% 1.91%
Denmark 2.49% 0.70% 1.78% 5.21%
France 2.30% 0.43% 1.87% 3.17%
Belgium 2.25% 0.43% 1.81% 2.63%
Austria 2.21% 0.31% 1.89% 0.67%
Germany 2.03% 0.37% 1.66% 3.23%
UK 1.84% 0.39% 1.45% 5.33%
Source: Dimson, Marsh, and Staunton

The Issue: Per Capita GDP is the Wrong Measure

The first chart is a reproduction of the chart from the yearbook that is commonly shared to make the case that real GDP and real equity returns have a limited or negative relationship. Even Dimson, Marsh and Staunton state investors do not capture economic growth (bold mine) based on the downward slope and r-square of 0.10.
The horizontal axis measures the growth in per capita real GDP, while the vertical axis displays the annualized real return, including reinvested dividends, from each equity market over the entire period since 1900. In the cross section of countries, it appears that equity investors do not capture benefits as a result of economic advancement, as measured by per capita real GDP.

Let's think about the apples to oranges issue here. Per capita GDP is the level of GDP per person, whereas equity growth is the equity returns in aggregate. This would be like wondering why you can't lose weight after eating a full pizza every night because it only has 300 calories per slice. What matters isn't the calories per slice, its what is the calorie level (economic output) in aggregate for the full pie.

Real GDP Accounts for THE Most Important Piece... Population Growth

Now let's take a look at an apples to apples comparison... the total real economic output produced (real GDP) vs the total real equity return over the same period. We now see a scatter plot that moves up and to the right (vs down to the right). I would note that this exact chart is produced ON THE SAME PAGE as the above chart in their 2014 yearbook, but has seemingly been ignored.

Despite the stronger relationship between real GDP and real equity returns, there is an even stronger relationship out there... population growth (i.e. the piece REMOVED from the per capita GDP calculation). I have not found this specific chart produced anywhere else in their yearbooks, but at a 0.56 r-square it is clearly the strongest relationship of the three (despite the lowest r-square result most often quoted), thus explains when you remove it why you get a non-existent relationship.

Summary: The Case for Asia ex-Japan ex-China is even Stronger

To bring this full circle, David Salem outlined that he has found value in Asia ex-Japan ex-China DESPITE its favorable growth and demographics. Instead, there is a case to be made that the allocation may make sense ONLY due to the favorable growth and demographics (it certainly does not appear to be a reason not to own this region). Combined with the attractive valuations in these markets, especially relative to the developed world, there is a very strong case to be made for diversifying to emerging / high growth countries.

Monday, March 20, 2017

Capturing Mean Reversion Via Momentum

Ben from A Wealth of Common Sense recently posted an update of his "favorite chart", which stacks the calendar year performance of a variety of asset classes.

As Ben points out:
There’s little rhyme or reason for how these things play out from year-to-year so it provides a good reminder for investors to understand that any single year’s performance in the markets is fairly meaningless.
While the year to year performance is rather random, this post will weigh the benefit of mean reversion (allocating to risk assets that have underperformed and stack low on the quilt) vs momentum (allocating to risk assets that have worked well and rank high on the quilt).

Asset Class Performance Over Longer Time Frames

The chart below shows the same asset classes that Ben highlighted, but rather than rank the asset classes by calendar year performance, it ranks them by rolling five year returns as of the end of February for each year (I picked end of February simply because that was the last data point).

There is a lot of interesting information here. One of the more interesting aspects is how mean reversion AND momentum can be seen over various time frames. Asset classes appear to be mean-reverting over longer periods (note the strong relative performance of US equities at the beginning of the 2000's, the poor relative performance through the mid to late 2000's, and the strong relative performance we are currently experiencing - while EM and international stocks were the opposite) and asset classes that have done well continue to do well (momentum) over shorter periods (note that if something did well the previous five years, it tended to stick around in the years to follow).

Allocating by Mean Reversion and Momentum

Using the February 1997 data as a starting point, we can look at the performance over several different time frames to determine whether mean reversion or momentum makes more sense. In this example I narrowed the universe down to equity-like holdings (US - small, mid, large-, International, EM, and REITs) as I personally don't necessarily believe commodities, cash, or even bonds should always be long-term strategic investment holdings (a conversation for another day).

Five year allocation: In this example, an allocation to the worst two performing asset classes over the last 5 years (mean reversion) and the best two performing asset classes (momentum) are held for the next five years. There is a HUGE caveat in this analysis as since 1997 there have been only 3 periods of rebalancing (so take the exact results with a grain of salt, though this has been verified in past research performed by Meb Faber).

Mean Reversion Momentum
2002-2007 21.10% 10.81%
2007-2012 1.80% 2.30%
2012-2017 8.67% 6.80%
Geometric Return 10.24% 6.58%

One year allocation: The reason I didn't bother to build out the five year allocation analysis further (to remove the issue outlined above) is that it doesn't really matter once you see the shorter-term results. In this example, we allocated to the bottom two / top two performing asset classes from the previous five years, but held on for the following 12-months (more data points than above, but we'll have a lot more below).

Mean Reversion Momentum
2003 -15.3% -19.9%
2004 64.5% 50.9%
2005 13.3% 21.0%
2006 13.9% 21.3%
2007 16.9% 23.5%
2008 -8.1% 4.4%
2009 -43.0% -53.0%
2010 76.9% 73.7%
2011 30.8% 26.2%
2012 -1.1% 1.4%
2013 15.2% 7.8%
2014 7.0% 18.7%
2015 2.9% 17.1%
2016 -19.0% -7.8%
2017 23.1% 22.0%
Geometric Return 8.0% 9.7%

Monthly allocation: In this case we allocated to the bottom two / top two performing asset classes from the previous five years, but held on for the following one month (performance is shown for the 12-months ending February of each year).

Mean Reversion Momentum
2003 -15.2% -14.7%
2004 48.7% 57.4%
2005 13.2% 12.3%
2006 13.9% 34.9%
2007 14.1% 23.9%
2008 -8.2% 5.4%
2009 -42.1% -56.1%
2010 78.8% 73.1%
2011 35.5% 24.4%
2012 -1.2% 1.6%
2013 17.4% 5.7%
2014 4.4% 24.3%
2015 3.0% 13.8%
2016 -18.9% -9.8%
2017 23.2% 23.6%
Geometric Return 7.5% 10.1%

Mean Reversion Captured via Momentum

Asset classes mean revert over longer periods, but this analysis provides a good starting point for the hypothesis that it can can be captured more effectively through momentum than by allocating to a down-an-out area of the market. The chart below shows that the best performing asset class was emerging markets for an extended period roughly 5 years after being the worst ranked asset class in 2002, REITs in 2012 were the best after being the worst ranked asset class during the financial crisis, and US stocks more recently were the best after ranking poorly for much of the period following the financial crisis.

For an investor the takeaway is good news... rather having to allocate to an underperforming asset class over the past x years, simply wait for that underperforming / cheap asset class to start performing well. While you may miss the exact turn, you may be able to capture the longer run success when the asset class starts working without having to deal with the pain that created the opportunity. 

Thursday, February 23, 2017

The Potential Return-Free Risk of Bonds

I've read too many posts / articles that outline why a rise in rates is good for long-term bond investors (as that would allow reinvestment at higher rates). While this can be true depending on the duration of bonds owned and/or for nominal returns over an extended period of time, it is certainly not true over shorter periods of time and absolutely not true for an investor in most real return scenarios... even over very long periods of time.


I'll take a step back and go to an interesting question posed by George Pearkes the other day (abbreviations removed for clarity):

Anyone care to estimate how big losses would be if you rolled 10 year US Treasuries at constant maturity for next 10 years w/ 25 bps of rate rise per quarter?
My response (completely translated from Twitter speak for clarity) was:
  • A 25 bp move per quarter is roughly a 2% loss per move given the current duration of around 8 years (0.25% x 8 = 2%).
  • So an investment would lose money each quarter until the yield (currently 2.4%) is greater than 8% (8% / 4 quarters in a year = 2%, which would offset the loss from the rate hike). 
  • Given an 8% yield would happen during year 6 (6 years x 4 quarters x 0.25% = 6% hike + current 2.4% = 8.4% at the end of year 6).
  • Year 6 is around midway of the 10 year horizon, so total return would be close to 0% cumulative over the ten years.
This was pretty close to being correct. The chart on the right shows the path of rates assuming a 0.25% rise per quarter, while the chart on the left shows the cumulative return for an investor (slightly above 0% over this period).

In the above example, a 0.25% rise per quarter (1% per year) is pretty extreme, but even a smaller 50 bp / year rise would result in lower returns (~10%) than no move (1.024^10-1 = ~27%).


Another problem for investors is that a rise in nominal rates does not occur in isolation. A rise is typically a function of a credit concern (much more likely with corporate / muni debt than treasuries), supply / demand imbalance, or inflation. For this exercise, I'll focus on the impact of inflation.

Nominal rates moved relatively closely with inflation from the late 1980's until the global financial crisis as investors demanded a real rate (nominal rate less inflation) of ~2% over that period (the recent period of QE pushed them much lower). It's the 1970's that highlights the real risk of inflation in a rising rate scenario; inflation overshot expectations, which created an environment in which inflation pushed real rates into negative territory (bond investors lost from rising rates and negative real carry).

Back to the scenarios... taking the same 0.25% rise in rates per quarter (1% / year) shown above and applying two alternative inflation paths, the left hand chart below shows the return profile if real returns were a constant 5% (i.e. inflation was consistently 5% below nominal treasury yields - in itself very optimistic for investors), while the right hand chart shows the return profile if real returns were a constant 2% (i.e. 3% higher inflation on the right hand side than left). In either scenario, the returns are decimated (not surprisingly... when inflation is higher, they are decimated more).

If you think the nominal return paths are too pessimistic (likely), let's take a look at a few scenarios that seem like pretty realistic possibilities based on market expectations for both rates and inflation. On the left hand chart we show a 20 bp rise per year with 1.5% real yields (settling at ~4.5% yields with 3% inflation) and on the right hand chart we show a 15 bp rise per year scenario with 0.5% real yields (settling at ~4% yields with 3.5% inflation). In each of these scenarios there are cumulative losses over ten years in real terms.

My takeaway... if you think rates are poised to rise in the future... think twice about owning them. While the risk-free return of cash is hard to accept at current levels, that return may end up being more attractive than the return-free risk of bonds if rates do rise.

Monday, January 9, 2017

The Asymmetry of Reaching for Yield at Low Spreads

Bloomberg Gadfly's Lisa Abramowicz (follow her on twitter here) outlined in a recent piece The Credit Boom that Just Won't Die the insatiable demand for investment grade credit.

Last month, bankers and investors told Bloomberg's Claire Boston that they expected U.S. investment-grade bond sales to finally slow after six consecutive years of unprecedented issuance. But the exact opposite seems to be happening, at least if the first few days of 2017 are any guide. The debt sales are accelerating, with the biggest volumes of issuance ever for the first week of January, according to data compiled by Bloomberg.
Lisa followed up this morning with a tweet outlining similar demand within high yield pushing the spread to treasuries to 3.83%, the lowest level since September 2014. That 3.83% option adjusted spread is the excess yield a high yield investor demands above a treasury bond of similar duration. Note that I did not say to be paid above a treasury bond of similar duration. The reason is historically high yield bonds have (on average) returned ~3.5% less than their yield going back 30 years due to credit events (the chart below is from a previous post The Case Against High Yield).

As a result, with a current option adjusted spread of 3.83%, if high yield bonds returned what they have returned relative to their spread ON AVERAGE since 1986, high yield bond investors should only expect a forward return that matches that of a treasury bond with similar duration (with a whole lot more risk).

But things can get worse

The next chart compares the option adjusted spread "OAS" of the Barclays High Yield Index relative to the forward excess performance vs treasury bonds of a similar duration since 1995. Note that yield to worst data goes back to the mid 1980's, whereas OAS only goes back to the mid 1990's hence the different time frame than the example above. The chart clearly shows the strong relationship between the two, but note that the upside potential of high yield is much more symmetrical at higher OAS levels, whereas there is more downside when starting OAS is at lower levels. This is driven largely by where in the credit cycle we are when OAS is low (often near the end) vs when OAS is high (often near the beginning).

In fact, we can see in the chart above that when we were at similar levels of OAS as we currently sit, high yield has never provided excess returns to treasuries more than its starting OAS. In fact, the chart below breaks out each of these ~80 starting periods when OAS was less than 4% and we can see that not only did high yield bonds underperform their starting OAS in every instance, the likelihood of underperforming treasuries has been much more prevalent (and with a higher degree of underperformance) than the likelihood of outperforming treasuries (the red line shows that on average high yield bonds underperformed treasuries by 2% at similar levels).

So if you are looking at the low yields of treasury bonds and searching for an alternative or believe that the spread of high yield may help cushion performance from any further rise in treasury rates, I would tread very carefully.