Quarterly Letter

“History doesn’t repeat itself, but it does rhyme.”

- Mark Twain

In our last quarterly letter, we discussed seven transactions from early 2017: two buys and five sells. We also provided an update on our then largest position, Express Scripts. There was zero analysis of the economy, asset classes, and central banks. We have been relatively quiet on the transaction front since then. It is now eight years into the current bull market, the Shiller1 price to earnings ratio is near 1929 highs, and other metrics, such as the S&P 500 price to sales ratio, are at all-time highs. With that backdrop, while we recognize almost every reader prefers to read about specific companies and investment ideas (and that is also what we prefer to write about), here goes a macro commentary.

The macro environment always provides the setup for reasonably specific absolute return prospects at the asset class level. Not this month, quarter, or year, but certainly over a seven-, ten-, or twelve-year period. In the case of equities, to simplify, future returns are a function of earnings growth and the starting and ending multiple investors are willing to pay. Earnings are cyclical, but they grow at a steady rate decade to decade. Investor sentiment regarding risk is also cyclical (it rises and falls as fear and greed are amplified), but decade-to-decade investors are willing to pay, on average, a similar multiple for the future earnings stream of equities.2 Thus, if earnings are at a cyclical low and investor sentiment is shifted toward fear, prospective returns for equities will be high. If earnings are at a cyclical high and investor sentiment is shifted toward greed, prospective returns for equities will be low.

Today, numerous factors (most prominently, central banks fixing interest rates near zero) have led to a macro backdrop where US profit margins are near peak AND investor risk sentiment is so risk-seeking that multiples on different measures of corporate fundamentals are at their highest level ever. From today’s starting point, future returns on US equities are expected to be negative over a seven-year period. That is, investors who buy the S&P 500 (or other US equity indices) today, should plan on losing money.3 In today’s environment, a similar situation exists for almost every single global asset class (e.g. foreign equities, US bonds, foreign bonds, etc.)

If we are not indexers, why does this matter? Many active investors will make the argument that in a world of thousands of securities, there are always pockets of opportunity. This is probably true. However, there are several flaws in this thinking. First, the macro is made up of all of the “micros” (i.e. individual securities). Second, in a world where absolute returns at the asset class level are very low, the universe of individual securities with good absolute returns is small. The chances of a cheap security being a value trap as opposed to true value are much higher than if everything is absolutely cheap. Third, even if one can identify a portfolio of investments with a high probability of strong relative returns, when absolute return prospects at the asset class level are low enough, they can swamp the relative return and even the cheapest individual security has a miniscule absolute return. Fourth, when absolute returns are very low at the asset class level, the likelihood of a significant correction rises considerably. When a correction happens, even cheap securities go down, especially in the initial wave of panicked selling. Finally, purists following the relative return doctrine ignore the most important fact. You cannot eat relative returns. If the asset class goes down by 40% and the relative return investor significantly outperforms and only goes down 30%, it is still a negative return. Even for active managers, “stock pickers,” the macro matters.

A Simple, Yet Historically Accurate Quantitative Model

In August of 2008, The Economist magazine published a short piece analyzing the accuracy of the institutional fund-management group GMO’s ten-year asset class return forecasts from July 1998 – just before the dotcom “bubble” was to burst. The piece began:

TEN years ago, GMO, an American fund-management group, was losing clients. GMO was skeptical about the dotcom boom and thought that equities offered poor value. Its performance lagged that of other groups who appeared to be more in tune with the “new paradigm” of the late 1990s.

The point of The Economist piece was that GMO’s skepticism of the “new paradigm,” while short-term painful, proved quite sound, their forecasting methodology generally correct, and surprisingly precise. Not only did GMO forecast each of ten assets class annual returns for the ten-year period to within a percentage point or so of accuracy on average, they also ranked the asset class returns in perfect order for eight of the ten. (They flipped foreign bonds and Treasury bills.) As expected, the S&P 500 provided very low returns over that ten-year period. Nil, to be exact.

The Economist continued:

… it also suggests that long-term market movements may be rather easier to predict than short-term ones. In the short-term, markets can be pushed to extremes, and thus away from fundamental values, by fear and greed. But bubbles don’t tend to last for a decade.

In other words, if you buy shares on a price-earnings ratio of 30-40, there is always the chance that they will shift to a rating of 50 or so over the following 12 months, allowing you to make money. But in ten years’ time, the shares will likely trade at around the market average of 15. You need a lot of earnings growth to make up for that potential halving in valuation. The odds are not on your side.

Today, GMO forecasts NEGATIVE real annual returns over the next seven years4 for seven of the eleven asset classes it currently tracks. Worst are US large capitalization equities (essentially the S&P 500) with an expected real annual return of -3.9% for the next seven years. US Bonds are also negative at -1.0%. Only emerging market equities, emerging market debt, and US inflation-linked bonds show modest positive real return expectations. And, emerging market equities are only expected to provide 2.9% real returns. This compares to the historical US equity return average of 6.5% real per year. That is not a lot of return for the historical volatility emerging market equity has provided.