Market Outlook: April 08, 2011

"Drivers of Equity Returns- The Short Term and the Long Term"

In this quarterly commentary, we would like to relate the drivers of short-term equity returns to their long-term determinants: two categories that are often very different.

To begin, let’s take a look at Figure 1: a chart from Merrill Lynch’s Quantitative Finance Group that shows the relative importance of three variables (cash flow yields, quality as measured by ROE, and beta) annually over a 25-year period. On a cumulative basis, cash flow yields were the most important variable, followed by beta and then “quality.”

Figure 1: After Beta It's Cash Flow

Source: BofA Merrill Lynch U.S. Quantitative Strategy, December 2010

Beta markets are momentum markets. Look at the late 1990s, for example, when NASDAQ tripled in a three-year period. Also consider the rebound from the market bottom in 2009: during this rally, beta mattered most. This surprised many pundits who had expected quality and strong balance sheets to lead the way. So what happened?

Two things. First, the Fed and other central banks lowered interest rates – to nearly zero on the short end in the U.S. – and fiscal policy became very expansionary. To understand the impact of this event, think of how a present value calculation works. When the denominator falls to nearly zero, the value of the numerator goes through the roof. And if that numerator is a long duration asset with option-like characteristics, the value explodes. Consider this example: J.P. Morgan’s stock has nearly tripled from its low in March of 2009 while Citicorp’s stock has nearly quintupled from its low of under one dollar in March of 2009. Equities are long duration assets but speculative equities have even longer duration measures.

The second event that boosted beta’s power as a market driver was the impact on corporate profi ts from a surge in government spending.

Taken together, these two events began to impact the equity markets in early April 2009. The lower the quality of the company, the better its stock performed as a result. This was “the power of zero¹” in action, and it was combined with fiscal policies unlike anything we had seen since the Great Depression. Today, with QE2 about to end and the effects of government stimulus coming to a close, the outlook for the beta trade is not good. As evidenced by the Merrill study, history suggests that when the beta trade ends, cash flow yield strategies will dominate: an outcome that, in our view, seems entirely logical.

With this in mind, let’s try to build a model for global equity returns throughout the next ten years. We’ll start with the current cash yield of 2.3% for the MSCI World Index. Add to that number an estimate for earnings growth and a number representing the annual rate of change expected for P/E ratios going forward (positive or negative). That sum will be the expected return for global equities for the decade ahead. To better understand the basics of this model, take a look at Figure 2, which illustrates the integration of the real economy and the financial economy as reflected in stock market levels.

Figure 2: Real Economy vs. Financial Economy

Source: Epoch Investment Partners, Inc., March 2011

Real GDP is the product of the growth in the work force times the measure of productivity gains. As many of us recall from the decade of the 1980s and repeated in the first decade of this century, this total can be turbo-charged by debt. Current sovereign debt to GDP ratios suggest further leverage-derived real GDP boosters are unlikely to be a factor in the future. So if the global workforce grows at a rate of 1–1.5%, and productivity continues at 1.5–2% per annum, real GDP will grow around 3% per annum. Add inflation of 1–3%, and we have nominal GDP growing at 4–6% for a decade.

Many studies have shown that corporate earnings in aggregate tend to mirror nominal GDP growth rates over time, thereby capturing productivity gains and hedging inflation.

Add an earnings growth rate of 4–6% to the current yield of 2.3% and we now have equity returns approaching 6–8%, exclusive of any P/E impact.

Where P/E ratios are concerned, it is important to remember that inflation – via the mechanism of interest rates – is their biggest driver. High inflation equals high interest rates and low P/Es. The opposite is true as well. Indeed, over a fifty-year period the correlation coefficient between interest rates and P/Es is -0.64, and over 20 years it is -0.8. This is a powerful statistical relationship.

If one assumes flat P/E multiples for the decade ahead, then one can also assume that equity returns will double over this period (a 7% per annum return, the average of our 6 to 8% range, will double the principal value in ten years). Importantly, equities will provide a 4% premium per annum over inflation for a “real” return of the same number. Thus, equities should trump bonds easily over the next ten years, as reflected in Figure 3.

Figure 3: S&P 500 vs. Bonds

Source: Bloomberg, December 2010

If the beta trade is about to end and cash flow yields are likely to come to the fore, free-cash-flow strategies will provide the most successful investing outcomes over the next decade. Our goal, as always, is to harness the power of these new market drivers, and to pass the value along to our clients.

¹ "The Power of Zero, The Dash for Trash and the Economic Growth Path”, by William W. Priest, April 28, 2010