Risk and returns – A Dangerous Mindset – Broyhill Asset Management.
- Artificially low rates have pushed prices artificially higher
- Higher prices today = lower returns tomorrow
- Different results require different thinking
Risk and returns at equilibrium
This is a scatter plot of asset class returns and volatility. The regression line depicts the risk-return trade-off under these equilibrium assumptions. In other words, the higher you move up the return scale, the further you move to the right on the volatility scale. This is normal. Generally speaking, more “risk" equals more reward (at least according to portfolio theory; value investors may take issue with this assumption).
Risk and return in the tech bubble
This is the same scatter plot as of June 2000. It shows US equities were priced for negative returns. It also shows that some assets were very cheap, despite the extreme valuation of other assets. REITS, for example, had an expected return of nearly 10%. Emerging market equities and debt were cheap. Small-cap equities were cheap. So, a well-diversified portfolio did just fine from 2000-2002 despite a 50% decline in large cap stocks.
Risk and return in the financial crisis
Asset class forecasts in June 2007 indicated a serious problem. Nearly all equity markets had negative expected returns. This chart shows a very different story from the one in 2000, which was a problem caused by the tech sector. In 2007, a negatively sloped regression line meant investors were paying for the privilege of taking risk. Cash and bonds were the only “safe” trade. At least investors could earn interest on safety at the time.
Risk and return . . . today
The most striking thing about this chart is how low the line is on the page. The dotted line shows what the line normally looks like at equilibrium (our first slide). Today’s slope is somewhat flatter. But the real problem is how low the line is on the page! It's 4% or 5% lower than normal! There are no “safe" trades that offer positive returns.
Real asset class return forecasts
As a result, real asset class returns from today's prices are likely to be significantly lower than normal. US large cap stocks look particularly expensive. We believe the overvaluation of large cap equities has been driven by fund flows into “bond-proxies" and dividend stocks.
A story about value spreads
Value spreads measure the difference in valuation between cheap and expensive stocks. When spreads are wide, the opportunities for value investors should be greater (other things being equal). Today, value spreads are about as wide as they have ever been. In the 90's extreme spreads were driven by extreme valuations across the tech sector. Today, interest rates have played a major role in widening value spreads. Bond proxies are the most expensive they’ve ever been. “Anti-bonds" the cheapest.
See the full slides below.