Absolute Return Partners’ letter title “A Brave New World”
“The deepest sin against the human mind is to believe things without evidence.”
In the the last two Absolute Return Letters I have argued why one should expect global GDP growth to be below average over the next decade or so, why interest rates should, as a consequence, remain low and why equity returns should also disappoint. Not as in negative returns but below the levels we have grown accustomed to over the past 30 years. If you have read those two letters, none of this should come as a surprise.
This letter will make the simple assumption that all of this will in fact happen and, before you scold me for being overly pessimistic, you should know that I am in pretty good company with this view. See for example here. It raises some important questions for investors and for the industry as a whole. What will that do to investor behavior? How will the asset management industry cope? Which asset classes will do best in a low growth environment? These and other questions will be answered in the following.
Does GDP growth matter at all?
It’s great to get to write the Absolute Return Letter. We economists tend to think we know everything – at least as far as the economy and financial markets are concerned. Nothing is healthier than being knocked off your pedestal from time to time. Example: The link between economic growth and stock prices. One would assume that a growing economy makes it easier for companies as a whole to make money which should again manifest itself in rising stock prices. In other words, economic growth and stock prices should correlate reasonably well. Right? Wrong!
At least in the short term (quarterly numbers), the two are virtually uncorrelated (chart 1). If one looks at stock prices in one quarter vs. GDP growth the following quarter, the correlation improves somewhat, but it is nowhere near perfect (the correlation rises to about 0.3). The conclusion is obvious. As an investor, one should not overemphasise the overall economy. As the famous investor Peter Lynch once said (and I paraphrase): “If one spends 13 minutes a year thinking about the economy, one has just wasted 10 minutes.”
Chart 1: U.S GDP growth versus S&P 500 (1970-2012)
Source: BNY Mellon Asset Management, Ecowin.
I can do one of two things now. I can stop writing the Absolute Return Letter altogether (but I enjoy it too much!) or I can do what I have always done – at least since I ‘grew up’ as an investor. I can focus on the long term, as I have come to realize that the short term is mostly about luck – at least for the majority of us.
Absolute Return Partners: Herding is changing financial theory
Now that I am doing so well taking apart financial theory, I might as well continue. One of the first and most basic things I learned when I did the finance part of my economics studies was that, over the long term, investors can expect to earn the highest returns on the riskiest investments. Why else would they ever consider investing in high risk in the first place?
Right? Wrong again. Over the very long term (since 1926), the 25% highest risk stocks have indeed outperformed the 25% with lowest risk but, more recently, the relationship has been upended. Since 1984, the riskiest 25% have generated an annual return of 4.1% whereas the 25% most conservetive ones have averaged 10.1% per annum (see details here).
One reason this might be true is that investors’ interpretation of risk has changed. For as long as I recall, risk in financial markets have been measured by volatility, and the numbers in the example above are also based on volatility. Somehow investors may think differently of risk today. Volatility might no longer be thought of as a good measure of risk.
I don’t buy that explanation, though. Volatility is still broadly recognised as the most quantifiable measure of risk in financial markets, even if some argue (and with good reason) that, to the long term investor, volatility shouldn’t really matter. The problem with that view is that investors often do make what in hindsight turn out be the wrong decision when volatility is high. Volatility therefore still matters.
A more probable reason is the recent trend towards benchmarking and indexing (i.e. herding). As more and more money is managed either passively, or on a strict benchmark basis, more and more capital is allocated towards the biggest names regardless of (perceived) risk. I will return to this subject later in this letter; suffice to say for now that more and more capital managed passively is quite likely to have altered an important part of financial theory. The result? A potentially serious misallocation of capital.
Absolute Return Partners: The dividend investor will return to glory
Let’s look at dividends. Investors young enough to remember only the last 20-30 years can be forgiven for not paying too much attention to dividends; however, in reality, dividends have accounted for a very large percentage of total returns on stocks over time. $100 invested in U.S. stocks at the end of 1940 turned into $174,000 by the end of 2011 if dividends were re-invested versus only $12,000 if dividends were not included.
However it’s not only in the distant past that dividends have mattered. Since 1972 dividend paying stocks have outperformed the S&P 500 by approximately 1.5% per annum (chart 2), and this period includes the mother of all bull markets (1981-2000), when dividends became very unfashionable.
Chart 2: Dividends still matter over the long term (1972-2010)
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Source: Guinness Atkinson Asset Management, Ned Davis Research
When looking at dividends’ contribution to total return over various decades, the 1940s and the 1970s stand out. In both of those decades dividends accounted for 75-80% of total equity returns, the highest of any decade since the 1940s (chart 3).
The noteworthy fact about those two decades is that they were also the slowest growing decades in the entire test period. Hence it is tempting to conclude that, in periods of slow economic growth, dividends assume a much more important role in terms of establishing the total return on equities.
Chart 3: S&P 500 returns for various decades since 1940
Source: Bloomberg, Guinness Atkinson Asset Management
If the next 5-10 years are going to be characterised by relatively slow GDP growth, equity investors are advised to pay more attention to dividends than has typically been the case since the great equity bull market took off in the early 1980s. I predict that dividend investing will become fashionable agan.
This raises a whole host of other issues. Is the dividend supported entirely by the company’s internal cash flow generation or does the company need to borrow? If borrowing is required, what will happen when interest rates eventually rise? These and other issues will not be addressed in this letter.