We finally got round to reading the Annual Long Term Asset Return Study published by Deutsche Bank. As always, this is a little treasure trove of charts and information and well worth the time spent on it.

What struck us almost straight away was the chart below, which illustrates how cheap or expensive asset prices (bonds and equities) are across 15 developed countries. As can be seen, these asset prices are the most expensive in over 200 years of historical data gathered by Deutsche.

Chart 1 – Bond and equity valuation for 15 developed countries

Although Deutsche spend a lot of time explaining why 1980 was an important inflection point, and what drove up valuations since then, what is important to understand is that central bank purchases of bonds and equities in recent years has further increased asset values to the current record high valuation. Furthermore, central bank purchases are not made for economic reasons. These guys do not care what price they pay, their sole aim is push up the price of bonds and equities, but they may be nearing the end of buying spree; at least until the next crisis is well upon us.

So what do these record high valuations imply for long term returns from assets? To help illustrate this, we will borrow from John Hussman’s work. Mr Hussman has shown empirically how measures such as market cap/GDP or market cap/Gross Value Added correlate with future equity market returns over say 12 years. The Chart below shows the forecast returns from a 60% US equity, 30% US bond and 10% cash portfolio (blue line) along with actual subsequent 12 year returns (red line) which have a correlation of 93%.

When we revert back to chart 1, Deutsche have marked 1980 which was a low point in terms of valuation. Comparing this to chart 2, we can see that John Hussman’s model was predicting more than 16% per annum returns at around the same time. As should be rather obvious, low valuation leads to the strongest of future returns for investors (over say a 12 year period). Conversely, the low forecasted returns apparent in 2000 did in fact lead to a poor outcome from the balanced portfolio.

Chart 2 – Projected returns from a balanced portfolio with subsequent returns (both over 12 year periods)

We would note here that the returns from bonds between 2000 and 2012 were in fact very good, and it was the poor return from equities that dragged the overall return down (equities having generated practically zero total return between 2000 and 2012). At present, forecasted nominal total returns for both US equities and 10 year bonds are about 1.5% per annum.

Of course, we have pointed this situation out quite a few times in recent months, and despite the odd little blip, equities have not plunged into a bear market, and bond returns have been much stronger than expected. Furthermore, with the authorities desperately trying to prop up financial markets, it almost feels like they have the power to avert any sort of financial pain. Not only do central bankers, the IMF and academic economists keep calling for ever easier policies, they continue to talk about a wider range of assets for them to buy. Just this last week, Larry Summers was floating the idea that Governments (presumably via central banks) should follow a policy of sustained and continuous stock purchases.

At this point in time, all we can say is that;

1. Equity returns have actually been disappointing since last summer in the US. In Europe and Japan, broad indices have made no price gains for about three years. So, it would appear that equities are already struggling even at a time when QE is larger than ever, rates are near zero or even negative and the elite are promising to do whatever it takes.
2. For long term investors, returns from mainstream assets (and we include most assets which have been bid up on central bank largesse such as property) are likely to be barely positive for a period of about 12 years.
3. Perhaps we need the pain of a bear market before the likes of Mr Summers get their way and governments again go to extremes to reflate markets, and maybe even help the real economy as well?
4. To add any value, investors need to do something different. This is likely to be looking at style diversification into trading strategies or removing the hassle of trading in public markets by venturing into the world of fixed capital, long lock up investments (akin to private equity structures). The best of these may well be set up in the future to take advantage of buying assets that become distressed during the next bear market.

The problem with trading strategies (e.g. macro strategies or CTAs) is that returns have been poor during a period of central bank largesse. However, they continue to offer investors a good diversification tool for a diversified portfolio. In fact, some macro managers have done better than others – for example, the near four year track record of the RMG FX Strategy has solid risk adjusted returns with low or even negative correlation to mainstream assets (apologies for the obvious marketing push there but do please contact us for more details if you want to or see HERE).

Despite the desire of our elite leaders to maintain the financial, economic and political status quo, we doubt that they will succeed. Indeed, we do not think the status quo can last much longer, and indeed just like in the early 1980s, the turn is likely to be a process rather than a single event. Who knows, perhaps we are well into that process already and we simply haven’t realised it yet?

We continue to believe that central banks are nearing so-called capacity limits, and the next stage of helicopter money will only be pursued after a nasty bear market. Furthermore, there are a number of unstable equilibriums evident today, with the European banking concerns garnering the most attention last week. Any one of a these unstable equilibriums could impact global markets at almost any time.

So the conclusion remains the same as last week. For those long term investors who are seeking to better the indices over the long term and protect their wealth during the next bear market, action needs to be taken now as waiting for the turn to be obviously behind will likely be bad for your wealth.

Stewart Richardson
Chief Investment Officer