For the six months ending June 30, 2017, Broyhill Asset Management generated mid-to-high single digit returns across the majority of our separately managed accounts. Detailed quarterly reports, including portfolio allocations, individual account performance, portfolio holdings, and transaction history, have been posted to our investor portal.1
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A Stock Market Lullaby
The market lulled investors to sleep in the first half of the year, with an unusually consistent climb higher. The S&P posted positive returns in each of the first six months. The second quarter saw only a single daily gain and loss larger than one percent. The last time the market declined by even 5% was over one year ago, making this the longest stretch without even a minor correction in two decades.
From time to time, it is normal for markets to experience periods of low volatility and high complacency. However, it is dangerous to come to expect them. It is even more dangerous to rely on them.
Temporary lows in volatility have historically concluded with exploding volatility and lower prices.
In the interim, investors tell themselves elegant stories to justify their aggressive decision making amidst subdued volatility. Every cycle comes along with its own convincing narrative. Recent examples include Greenspan’s ability to eliminate the economic cycle during the 1990s; Bernanke’s Great Moderation; and today’s relentless inflow of capital into passive investments. No matter how great the story, the conclusion is always the same.
Stories and Storytellers
Master storytellers capture everyone’s attention. We gravitate toward experts able to spin compelling narratives with conviction. We take comfort in hearing strongly held opinions. The simpler the story and the more confident the storyteller, the better.
Good stories put us at ease, connect with our emotions, and invite us to let down our guards. The best stories even alter how we process information, making us less likely to seek out inconsistencies. We become seduced by the narrative. We accept arguments without questioning the assumptions.
At the moment, the most popular story amongst market participants lies at the intersection of supply and demand, where the marginal buyer sets the price for risk assets. Today, the marginal buyer is a machine with no regard for price. When markets go straight up, the machines are given the green light to increase risk exposure. More buying drives up prices, and higher prices trigger more buying. What could possibly go wrong?
For one, machines do what the algorithms tell them to do. Nothing more.
Fundamental analysis plays no part in this narrative. Price doesn’t matter to a machine. It’s all about supply and demand. And demand is ultimately driven by the narrative. But narratives can change.
A Very Strange Thing to Do
If you can’t beat ‘em, join ‘em. In its simplest form, this is the argument driving the machines and the record inflows into passive investments. It’s a very strange thing to do at this point in the cycle.
It seems that investors have blindly accepted another compelling narrative. They’ve let their guard down at a very inopportune time without questioning the assumptions behind the story they are being sold.
Passive investors are buying the S&P 500 today for 30x normalized earnings. The implicit assumption they are making is that price doesn’t matter. Yet a century of historical data clearly shows that price is the most important determinant of long-term returns.
In the long run, price follows value no matter how compelling the prevailing narrative of the day. We know today’s price. Value is a more uncertain concept, but it can be estimated with a dash of reason and a dollop of logic.
Forecasting a range of long-term returns lacks the sex appeal of a good story, but it is likely to prove far more accurate than a blind-folded chimp chucking darts at market pundits.
Numbers Don’t Lie
Over the last century, the US stock market has generated average returns of about 9% annually. Historical returns can be broken down into the building blocks illustrated in the graph below.2
To forecast a reasonable range of future returns, we’ll examine each of these building blocks – dividend yield, earnings growth, and changes in valuation - in turn, beginning with the market’s current yield.
The beginning dividend yield is a known quantity and hence the easiest “forecast” - no room for story telling here. While the long-term average dividend yield on the stock market has been about 4.5%, Today’s dividend yield is below 2%.
So right out of the gate, we should knock 2.5% off the top.
Bottom line: best case scenario for future stock market returns is 6.5% (9% - 2.5% = 6.5%).
Real earnings growth varies widely from year to year, but the long-term trend is robust. While every cycle is accompanied by colorful stories of accelerating earnings growth, real earnings per share have continued to compound at 1.5% annually over the past century. This rate of growth is far lower than typical Wall Street forecasts for a simple reason. One is fact. The other is opinion.
With a starting dividend yield below 2% and long-term average earnings growth of 1.5%, a reasonable estimate of long-term real returns around 3.5% seems like a decent starting point.
That’s a good bit lower than the equity market’s historical 6.5% real return, but it’s a more realistic forecast than the typical, “past is prologue.” And we haven’t even considered the fact that current profits are far above trend and profit margins are hovering near all-time highs. Both variables point to lower future earnings growth, but we’ll give the market the benefit of the doubt for now.
To get from real returns to nominal returns, we need to consider inflation. Over the past century, US inflation has averaged about 2.5% per year. However, sluggish, debt-fueled economic growth since the financial crisis has resulted in sluggish inflation as well. Over the past ten years, average annual gains in the CPI have been closer to 1% -1.5%. We’ll take the high end of that range and tack it onto our 3.5% real return estimate. This gets us into the neighborhood of 5% nominal expected returns.
That doesn’t sound awful relative to current yields on cash, but it’s not the whole story. Over the past century, changes in valuation have added about 0.5% to the average return on the market as PE ratios have gradually increased. Suffice it to say that a further increase from today’s levels is unlikely.
Historically, investors have paid about 15x for a dollar of earnings. Today, passive investors in the S&P have bid up that price to 30x earnings – roughly double the historical average and a level only exceeded twice in market history. Research from Goldman Sachs Asset Management illustrates that at current valuation levels, the S&P has delivered single-digit or negative returns 99% of the time.
High valuations can persist for years, but investors must recognize that they are betting the house on inflated prices to achieve, at best, single digit returns.
Even a minor reversion in valuation from