Transcript
A (0:02)
If you struggle to ramp up a refresh quickly on a long list of public companies. Listen to this Most research platforms make you dig through endless dashboards and raw data and charge a premium for it. Tenzing Memo is an AI powered market intelligence platform built for professional investors offering real time company research and insights without filters and dashboards. You just open it and get what you need in a tenth of the time at at a tenth of the cost, as one CIO put it. Tenzing Memo takes us from zero to one in understanding a candidate not in days, but in minutes. Get up to speed faster in nearly 6,000 public companies. Try memo free at Tenzing memo.com register with Code Enterprise to unlock an extended free trial.
B (0:55)
Hello and welcome to the Enterprising Investor, the flagship investment podcast for CFA Institute. I'm Mike Wahlberg and today's guest is Rob Arnott, Founder and Chairman of Research Affiliates and one of the most influential voices in quantitative investing. With decades of experience challenging conventional wisdom in asset pricing and portfolio construction, Rob has authored well over 100 academic papers, many of them award winning and pioneered strategies that blend theory with real world application, including the practice of tactical asset allocation. Listeners may recall we had Ed McQuarrie on the show last year to talk about his new paper that challenged the long held assumption that equities have always reliably outperformed bonds. I remember that conversation well because he told me at the time and I forget if this was offline or in the episode itself that he was headed then in January so January 25th to a CFA Institute webinar to discuss or probably defend the findings with Jeremy Siegel, Rob here, Roger Ibbotson, Elroy Dimson and Lawrence Siegel. And I admit that hearing that list of panelists made me a little afraid for Ed at the time. The good news is that today we are talking about a furtherance of that research research that Rob conducted. Together with Ed. They recently co authored a paper this past spring titled Fear Not Risk Explains Asset Pricing. This article offers a provocative rethinking of how markets actually reward investors and what we've been getting wrong for decades. I look forward to hearing more. So welcome to the show, Rob.
C (2:25)
Thank you very much. It's a privilege being here.
B (2:27)
Before we get going here, tell me a little bit about that webinar. How did that go and how did that conversation go and how did that sort of inspire you to work more with Ed on this topic?
C (2:36)
Well, firstly, these conversations are wonderful fun because we all have a mutual admiration society and deep respect for one another. We just have different opinions. And Jeremy Siegel's very important contribution to the world of finance has been his work on the equity risk premium and his demonstration that over long periods of time stocks have reliably beat bonds. For the investor who's patient enough, and that's the key issue. A lot of people read his writings as suggesting that an investor with a five year horizon, for instance, hardly anyone has a horizon much longer than that, even though they should. The odds of success for stocks on a rolling five year basis is actually not brilliant. And Jeremy would be the first to readily acknowledge that. Ed McQuarrie's contribution was to challenge stocks for the long run by looking at the long term history. He's an empiricist and he's a superb empiricist. He took a deep dive into the sources of long term returns going back well before the CRSP Data starts in 1926. We had the Cowles Commission taking dotted back to the 1870s. We had Schwerck taking data back to 1802 and these were based on studies that turned out to be more superficial than people realized. And Ed took the data back to 1802 and found that stocks more broadly defined than short did, more broadly defined than Cowells did, had performed a little worse than people realize and that bonds had performed a little better, which means that the risk premium had been smaller. Now the other thing that Ed and I both noticed is that the data covered by the CRSP data going back to 1926 and by the Ibbotson Sinque field data going back to 1926 is heavily dominated by a half century from 1950 to 2000. Why is that important? The stock market went from an 8% dividend yield to a 1% dividend yield in that 50 year span. That means, and we have a working paper called Revaluation Alpha which points out that if historical return includes a revaluation, and you assume that historical return is predictive of the future, tacitly you're predicting that the revaluation will continue Eightfold. Revaluation. So does that mean that we should expect 50 years hence that the dividend yield on US stocks will be 15 basis points for a dividend yield and the CAPE ratio would have to rise to about 300 to match that. Okay, do you want to assume mean reversion, that is to say when revaluation happens it reverses course? That's one possibility. That's, that's what Jeremy Grantham assumes in his seven year real return forecasts. It's a little dangerous because you can enter a new world where there's new risk tolerances. People are living longer, they don't have. If, if your life expectancy is 50, 50 chance you're going to be alive in 10 years, chances are that you're going to demand a pretty high risk premium to not spend today. And if your life expectancy is 40 years or 60 years, you're going to demand a smaller risk premium. You're going to be fine with a lower risk premium. And so if the normal risk premium changes, then revaluation can be sustained. But you don't dare assume that it's going to persist. Now back to the second half of the 20th century. That 50 year span saw an Eightfold rise in valuation of stocks measured against dividends six fold rise on a Cape ratio basis. That is huge. The revaluation alone accounts for 400 basis points of the stock market's return per annum for 50 years. 400 basis points a year for 50 years is attributable to revaluation. A, you need to take that out. So if the excess return for stocks was 8% over that span, absent revaluation, it was 4. And if you take the revaluation out of the entire century long span covered by the Ibbotson data, the Ibbotson data will have a century as of the end of this year. And that century long span would have been influenced to the tune of about 200 basis points a year. So when people look at the past and say stocks have beat bonds over the last century by four and a half percent per annum compounded, fantastic. Except two of that was revaluation. Take that out and you're looking at 2.5%. So these are important observations because the risk premium is smaller than people think. If the risk premium is smaller than people think and the variability of returns is exactly what people think it is, then that means that the amount of time you have to wait to have confidence that you're going to win with stocks goes up with the square of the decline in risk premium. So if people are assuming five and it's two and a half, then that means you have to wait four times as long to have confidence that stocks will be bonds. And sure enough, when Macquarie redid the analysis with painstakingly reconstructed stock and bond returns over the 125 year span ended in 1926, painstakingly reconstructing those returns to be more accurate and more complete picture. What you find is that there was the entire 19th century, Bonds beat stocks the entire century. Most of us don't have a century to wait for the risk premium to kick in and reward us for our choices. Which tells us that the stock versus bond decision is lightly based on a presumptive risk premium and heavily based on a tactical evaluation of which is priced to produce a higher return. Back in 2000, I wrote a paper, A Death of the Risk Premium. It got published in the Journal of portfolio management in 2001 and basically it said, look, stocks have a yield of 1. TIPS have a yield of 4. Stocks have inflation participation in the dividends. TIPS have inflation participation in the coupon. And so defining the risk premium using tips, not corporate bonds is actually a more sensible comparison. Very few people to this day, quarter century later have picked up on that. But still, it's a relevant comparison. So all stocks have to do is have real earnings and dividend growth of 3% a year, which doesn't sound like a big hurdle. 3% real growth in earnings and dividends to justify being a 3% lower yield. That's what it would take to have a risk premium of zero. All right, over the last hundred years, what's been the real growth of earnings and dividends? About 1 1/2% a year. So if real growth is 1 1/2 and you've got a 3% shortfall on the 30 year tips, we're back in approximately that circumstance today, but with a much smaller gap. You've got long tips yielding two and a half, stocks yielding one and a quarter. So real growth has to be one and a quarter in order for stocks to be long tips. The historic norm is a little over one and a half. All right, that means you might have a positive risk premium of 0.2 or 0.3%. Nobody buys stocks expecting a risk premium of a quarter percent. And so, tacitly, it's a bet. Stocks are a bet that earnings and dividend yield will be much more robust than has been the case over the last hundred years. Is that possible? Absolutely. That's what Jeremy Siegel would argue. So this all forms the basis for us recognizing. I've long thought that CAPM is built on a shaky simplification of risk aversion. And this is not a criticism. A Bill Sharpe CAPM was a brilliant innovation, an enormous leap forward, but it tacitly assumes that investors hate downside risk and upside risk equally.