GMO and The Persistence of Stock Market Returns
I have written before about the high quality of opinion in Jeremy Grantham’s shop, GMO. Now besides Mr. Grantham, I found another analyst with a similar sensible point of view, Ben Inker.
In Mr. Inker’s April post on the GMO website, he writes of the long term success of common stock equity investments and their tendency to revert to the mean. This concept is one of which I am very fond and have written often. It is well proven in investing literature over a very long period of time.
However, even those as illustrious as Mohamed El-Erian and the PIMCO shop have made recent claims that “this time its different”, in respect to the credit crisis and subsequent recovery. Every time I see those words, I know that we are at a point of transition. We heard that refrain often in the late 1990s with equity prices rocketing ever higher and price multiples of earnings going stratospheric, beyond 100 in many cases. But the purveyors of investment advice reassured us: “don’t worry, this time it is different”, and that we should expect never to see again a multiple of 10 on the market or even on individual stocks. Economic management had flattened the business cycle and therefore stocks had become riskless, justifying the extreme multiples, so the logic went.
We learned in 2000-2003 that this was not the case at all and that the business cycle had not been vanquished. And then once again, during the housing boom from 2003 to 2006 we heard that same refrain: “don’t worry” house prices had gone to a new permanently higher level and we would never again see house prices decline. It was supposed to be a guarantee. Now, from none other than the PIMCO shop we hear, start worrying, this time it IS different, stock prices will not soon recover.
But Ben Inker demonstrates the case why stock prices will indeed recover, and likely very soon. The stock market has a life of its own. As humans, we cannot understand all the inputs to the market that influence its every direction. We are prone to fear and greed at the most extreme times. Recently, our senses have been overcome by fear. At cocktail parties we now share stories of financial destruction: the halving of our retirement accounts to “201Ks”, and who we know that invested with Bernie Madoff. There has been nothing but gallows humor to share the past twelve months and we are stricken by the idea that we will never be able to retire. At times like this, the market will do what everyone least expects and once again will revert to the longest term mean.
Ben Inker in his post makes the point that:
“The first thing to recognize about equities is where their value comes from. Stocks are worth the present value of the future cash flows they will deliver to their owners. Since stocks do not have a(n) expiration date and dividends grow over time, the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future.”
It is this long term nature of common stock equity that makes reversion to the mean so likely. As long as an equity has a long life and the company it represents survives intact and continues to grow its profits and cash flows (the source of dividends) with the rate of the economy, the near term events do not really matter to value.
Analysts and business brokers have long known about this phenomenon and often use the pricing model called “discounted future cash flows” to value companies. It is surprising this approach isn’t discussed more in stock analysis made available to the public. Too much emphasis in daily market pricing is placed on the immediate future, current economic trends and next quarter’s earnings, when it is really the long term viability of the company in question that is most important to its long term value.
I also have long discussed the tendency of an economy to quickly fill the void in spare productive capacity once the economy revives. This has been true throughout history regardless of what happens to an economy. Amazingly, even the World Wars did not much diminish the productive capacity of the worst damaged economies: Germany and Japan, as shown in the Inker piece. But an economy that experiences a severe decline but with damage only to capital and not infrastructure or population, like the American economy most recently, very quickly fills the production void as if it were never there. With central bank encouragement through the re-liquification of banks and “quantitative easing” or money printing, there is no reason the world economy cannot get back to where it was at the end of 2006 within five years or by the end of 2013. 201Ks will become 401ks again, and maybe even 501ks if fully invested throughout the decline. From Inker’s piece:
“The Great Depression is far and away the most striking period on the chart (see link below for charts). Real GDP fell by 25% from 1929 to 1933, in what was easily the worst economic event to hit the U.S. since the Civil War. But that fall, as extraordinary as it was, was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually (by 1945) got back onto its previous growth trend as if the Depression had never happened.”
Why does this phenomenon exist? It is not very important why, so much that it is, but we can speculate: The sum total of man’s knowledge about the world, science, the arts, economics and production cannot be destroyed. It is always preserved and passed from generation to generation, each building on the last. To rebuild an economy to a previous level or beyond only requires a willing political system, an educated population that can employ the accumulated world knowledge and capital. And capital is always available to invest in areas of high return: where it is needed most. Damaged economies apply enormous suction to global capital.
For a very interesting read, I reference the piece by Ben Inker and have posted it in the “Wealth-ed” archives