WHAT is the right way to invest for the long term? Too many people rely on past performance, picking fund managers with a “hot” reputation or backing those asset classes that have recently done well. Just as fund managers cannot be relied on to be consistent, returns from asset classes are highly variable. The higher the initial valuation of the asset, the lower the future returns are likely to be.
That is pretty clear with government bonds. Anyone buying a bond with a yield of 2% and holding it until maturity can expect, at best, that level of return (before inflation) and no more. (There is a small chance the government might default.) With equities, the calculations are not quite so hard-and-fast. Nevertheless, it is a good rule-of-thumb that buying shares with a low dividend yield, or on a high multiple of profits, is likely to lead to lower-than-normal returns.
So a sensible approach to long-term investing would assess the potential returns from asset classes, given their valuations and the fundamentals, and allocate assets accordingly. That is what GMO, a fund-management company, has been trying to do for decades. It has made some common-sense assumptions about the fundamental drivers of returns and then assumed that valuations would return to average levels over a seven-year period.
In one sense, this process has been a success. The assets that GMO thought would perform well have offered relatively high returns; the assets it thought would perform badly have offered low ones. But if the ranking has been correct, the level of return has not been. Assets that GMO thought would yield a negative return of -10% to -8%, for instance, have in fact suffered average losses of only -2.8%.
GMO’s forecasts have been pretty accurate for asset classes such as emerging-market bonds and international stocks; annual returns have been within 1.5 percentage points of its forecasts. But for American equities, GMO was too gloomy, underestimating returns by around four percentage points a year.
The reason for this error is pretty clear. Equity valuations have not returned to the mean, as GMO thought they would, but have stayed consistently above their historical levels. GMO was fairly accurate in its forecast for dividend growth, but its erroneous estimation of valuation accounted for all the forecast error.
There are two possible conclusions. One is that GMO is simply wrong about mean reversion. Equities have moved to a new, higher valuation level. But there is some justification for a valuation shift: American profits have been high, relative to gross domestic product, for a long period of time. This may be a result of monopoly power in some industries, or perhaps of the reduced bargaining power of workers in an age of globalization.
A more obvious argument is that, with yields on cash and government bonds so low, investors are willing to pay a high price for equities because they represent their only hope for decent returns. But given the low level of dividend yields and the sluggish rate of economic growth, profits will have to keep rising as a proportion of GDP to allow high equity returns to continue. That seems unlikely.
© 2017 The Economist Newspaper Ltd., London
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