Alpay Kaya, CFA

La vérité existe. On n'invente que le mensonge. —Braque (Truth exists. One only invents falsehood.)

For Whom the Pendulums Swing (Excerpt from Value in Volatility)

Some finance professionals promote B&H (value or market variety) as a ‘disciplined’ approach that has performed well over the ‘long term’. Unfortunately, too many seek to abstract their own experience from reality. They fail to realize that their own experience (even if 10/20/30 years in the making) is nothing more than one example of what is realistic. Basing claims on the quality of one’s research is preferable to the quantity of one’s experience (though the simple act of storytelling makes the latter much easier). For the uninitiated, quality research in the field of finance requires quality mathematics.

Interest rates are currently at cycle lows. Given the length of these cycles, the upcoming increasing rate trend will constitute a market regime few if any have experienced. It is true that there is no schedule for when rates will increase; after all, the 10y Treasury is not quite at zero. Regardless of when or how it begins, the next rate regime will be one of increasing rates. US rates increased 1954-1981, decreased 1981-2013 and are continuing to be held low by central bank intervention.

What is the definition of ‘long term’? The most recent rate cycle was about 60 years. How does that compare to your investment horizon? How many years of experience do you or your advisor have? For a significant portion of the previous increasing rate regime, Fig. 1 shows equities to have offered investors decidedly substandard performance.


Figure 1: Long-term average return. Shown are graphs of 10-year US Treasury yields in gray (data source: Federal Reserve) and average annual returns from holding the S&P500 over the ensuing 10 years in black (data source: Yahoo! Finance). The returns are forward-looking; in July 1968 for example, an investor rejecting the 10-year rate slightly above 5% and instead choosing to buy & hold the S&P500 for 10 years (1968-78) would have earned zero return.

Never mind outsized returns justifying the uncertainty taken on by investors, equities often returned less than bonds. For a significant portion of that period, 10-year buy & hold returns were near zero. Ahhh, the reward for being ‘disciplined’ over the ‘long term’. The only way to make an acceptable return on a market portfolio in the increasing rate environment was from volatility (e.g., buy low & sell high).

What about equity returns in the early stages of the cycle? For 10-year holding periods beginning in the early 1950s and ending in the early 1960s, equity yields were fairly high.  The reason is simple. For the 20 calendar years following WWII (1946-1965) nominal US GDP growth averaging over 6% drove equity returns despite rising (but still low) rates. Once the 10-year rate passed 5% however, the even-higher nominal GDP growth rates of the 1970s (9+%) couldn’t raise forward-looking equity returns significantly above increasing bond yields. Only after 10-year equity return windows began to overlap with the decreasing rate regime (1981 onward) did equity performance match (yes, match) that of bonds.

It is also only after forward-looking 10-year equity returns began to overlap with the decreasing rate regime that the positive return confidence levels shown in Fig. 2 increased to acceptable levels.


Figure 2: Long-term statistical significance. Shown are graphs of 10-year US Treasury yields (gray, right axis) and confidence levels of statistical significance (black, left axis) that forward-looking S&P500 10-year returns are positive.

They remain above 90% until the 2000 Tech/Dot-Com bubble, after which the effect of the 2008 financial crisis is obvious. Note that the 10-year confidence levels in Fig. 2 are not for equity returns being greater than 10-year bond yields, just greater than zero.

Of course, investors want more than just positive returns. Holdings with uncertain future values should provide returns in excess of risk-free rates and should do so to a degree justifying the associated volatility, for which the Sharpe ratio is a widely accepted measure. For an extended period in the most recent increasing rate regime, Fig. 3 shows equities to have not fulfilled this expectation.


Figure 3: Long-term Sharpe ratio. Shown are graphs of 10-year US Treasury yields (gray, right axis) and annualized Sharpe ratios for holding the S&P500 over the following 10 years (black, left axis).

For over 10 years straight, the US equity market’s forward-looking 10-year Sharpe ratio was negative.  This includes all 10-year windows beginning with mid-1963 (to mid-1973) through mid-1974 (to mid-1984).

Clearly, the B&H strategy yields different results according to rate environment, with the upcoming one not boding well for this approach. Over the past three decades, rates decreased from record highs to record lows. In general, it is important to remember that a strategy performing well in one rate regime should not be assumed to do so in another.

When ‘everybody knows’ something, it is a good idea to examine the claim being made, if only to verify that anybody knows anything. A basic tenet of equity investing is that profits drive investment returns. If profits increase, the firm’s value should likewise increase. This makes perfect sense when assessing the value of a firm. What about in aggregate, the profits of all companies?  Increasing corporate profits should serve to support an increasing equity market. Again, this makes perfect sense when assessing the value of all firms. . . at least it does on the margin, for incremental changes.

When it comes to such a large part of the overall economy however, it is important to remember that the economy is finite. As large as it is, it is finite. For this reason, the ratio of corporate profits to GDP comes into play.

Consider the historical behavior of corporate profits relative to GDP. Just as stock prices may increase due to increasing profits or P/E expansion, aggregate corporate profits may increase due to increasing GDP or profit/GDP expansion. Over the decreasing rate regime just completed, Fig. 4 shows corporate profits to have increased from a record low of about 3% to a record high of over 11% of GDP.


Figure 4: Supporting equity valuation. Shown are graphs of 10-year US Treasury yields in gray and after-tax corporate profits normalized by GDP in black (data source: Federal Reserve).

The relationship between a slice of pie (corporate profits) and the pie itself (US GDP) is addressed in the following quote from Warren Buffett (“Mr. Buffett on the Stock Market”; FORTUNE; retrieved from; 22 November 1999).

When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.

Just to be clear about Fig. 4: increasing profit/GDP means the component factor is outpacing the aggregate. If corporate profit growth forever outpaces GDP, then eventually GDP will consist of nothing other than corporate profits. He goes on to argue that a high profit/GDP ratio will mean-revert due to increased competition and political forces.

For the past 30 years, both decreasing rates and profit/GDP expansion have supported investment returns of the equities asset class. Each factor’s pendulum has literally swung from one record-setting extreme to another, and those who bought & held equities profited. The benefits associated with heretofore changing levels have been priced in. Even if these metrics don’t reverse course but simply level off, the trend will have been broken. The assumption of future benefits requires one to believe both that rates continue to go lower and profit/GDP levels continue to go higher.

People with fewer than 30 years experience will have first-hand knowledge of neither an increasing rate environment nor a decreasing (or even level) profit/GDP environment. If your experience does not include multiple regimes, do not pretend they don’t exist or the factor in question to be irrelevant. Reality is subject to neither your awareness nor your acknowledgement.


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This entry was posted on June 17, 2013 by in Authored Books, Finance and tagged , , , .
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