Brace Yourself for Mediocre Returns - Part 2, The Equity Edition

While equity markets have more "moving pieces" than their fixed income counterparts, their longer-term outcomes can likewise be broken down into a handful of understandable and forecastable components. When approached in this manner, we see that returns from US and Japanese equity markets in the coming decade are likely to be poor, while returns from the currently "troubled" markets of Europe are likely to be substantially better.

It is a given that there are only two ways to make money from an equity - either you are paid a stream of dividends, or the price another party is willing to pay you for your shares differs from the price you paid (Dividend + Price Change).  In general, the Dividend component is readily observable and tends to be less volatile while stock Price Changes are more volatile and, in the short-run, more unpredictable.

To better understand the portion of return due to Price Change, we can further decompose that piece into Earnings Growth per share and the price one is willing to pay for each dollar's worth of those earnings (i.e. the P/E Ratio).  Both are somewhat volatile, but less so than the overall Price Change itself.  To simplify further, I like to sub-divide the Earnings Growth component into Revenue Growth and the change in the profitability of those Revenues (i.e. the Profit Margin).  Taking all this together then, if we know with certainty just four variables: Dividends, Revenue Growth, Profit Margins and the P/E Ratio, we will know with certainty the return from an equity (or equity index).

Fortunately, two of these components are relatively stable over a period as long as a decade (Dividends and Revenue Growth), while valuation and profitability are more volatile -- and it is this change in Margins and the P/E Ratio that ultimately drives returns.  Thus a sensitivity analysis featuring these two unknowns is called for.

Equity earnings tend to be cyclical over time (see chart) and gauging market value on a single, spot observation can be mis-leading -- especially when earnings are well above, or well below, their trend.  As of June 30th, the P/E Ratio on trailing, reported earnings of the S&P 500 index was 15.5x, below the longer-term norm of 17.0x (the median valuation since Dec 1959).  Based on this, one might conclude that the market is cheaply-valued.  What is left out of such a simplistic analysis is that the earnings part of that calculation is not at the norm, but rather a cyclical high.

Instances such as this tend to occur when margins are well above their norms, even as they are understood to be generally mean-reverting.  Today, S&P 500 margins are near one of these cyclical peaks.  The chart below was first published in my initial blog posting, "The Profitability Illusion" (June 15th), and depicts year-end S&P 500 net margins over the past 15 years.

A longer-term chart using a different set of data, the National Income and Product Accounts from the Bureau of Economic Analysis, which details economy wide profits, delivers much the same message (note how current margins appear to have broken out of their long-term channel.  I showed in "The Profitability Illusion" how this is largely due to the low interest rates engendered by the Fed's QE policies).

Thus, a valuation analysis which adjusts for the margin's deviation from its norm and which assumes dividend growth in line with earnings (as long as the current payout ratio is near longer-term norms), revenue growth in line with historical trends (typically that of nominal GDP) and a valuation component (P/E ratio) that returns to its long-run median over a period of ten-years should provide a decent assessment of where returns are headed as cycles run their course.  Those who disagree with my assumptions of a return to normal margin can use the accompanying sensitivity tables and observe returns under a range of margin and P/E inputs.  However, I would direct doubters back to "The Profitability Illusion" which discusses in some detail why over 2 percentage points of the current S&P 500 margin is illusory and unlikely to be sustained.  In any case, the range of returns can be illuminating and the dispersion of returns, not as wide as one might assume.

I turn first to the United States and use the S&P 500 index as a proxy for US Equities.  Over the past 50+ years, a median valuation of 17.0x earnings is the norm (I choose to use a median as opposed to an average because out-sized values can distort its calculation.  In full disclosure, the average P/E has been 17.6x).  Margins have averaged 6% for the past 50 years and have proven throughout to be mean reverting.  Today, though they stand near record highs of over 8% and in this analysis it is assumed they will slowly return to the 6% average.

 For this exercise, we also assume 5.5% annual compounded nominal revenue growth (in line with historic norms) and a 2.14% annual return from dividends (the current yield).  Putting this all together, our best guess return estimate for US Equities over the next 10 years is 3.9% per year.  If you want to assume record margins continue, you could up that expectation (see table below), but just to 6.8%.  Under no reasonable scenario, are double digit equity returns in sight.

S&P 500 10-Year Return Estimation (5.5% Nominal Revenue Growth, 2.14% Annual Dividend Return, Various Margin and P/E Scenarios)

13x          15x         17x         19x           21x 4.0% -2.8% -1.4% -0.2% 0.9% 1.9% 5.0% -0.6% 0.8% 2.0% 3.1% 4.1% 6.0% 1.2% 2.6% 3.9% 5.0% 6.0% 7.0% 2.7% 4.1% 5.4% 6.6% 7.6% 8.0% 4.1% 5.5% 6.8% 8.0% 9.1%

Taking Japan next we conduct a similar analysis, though using the historically lower 3.0% margin levels and nominal revenue growth.  Though Japanese valuation data is distorted somewhat by 10+ years of a great bubble, we feel a normalized P/E ratio of 20.x, higher than that of the US, can be argued, though we show a range of 12.5x to 27.5x in the sensitivity below.

MSCI Japan 10-Year Return Estimation (3.0% Nominal Revenue Growth, 1.77% Annual Dividend Return, Various Margin and P/E Scenarios)

	12.5x	15.0x	20.0x	25.0x	27.5x
2.0%	-5.7%	-4.0%	-1.2%	0.9%	1.9%
2.5%	-3.6%	-1.9%	0.9%	3.2%	4.2%
3.0%	-1.9%	-0.1%	2.8%	5.0%	6.0%
3.5%	-0.4%	1.4%	4.3%	6.7%	7.7%
4.0%	0.9%	2.8%	5.7%	8.1%	9.1%

Moving on to the European markets and the UK, we reach a somewhat happier, though still below historic, level of return.  For the UK market we use similar revenue (5.5%) and normalized margin assumptions (6.0%) as we do for the US.  For the continent, I discount both revenue growth and margins by 0.5%, in line with historic observations.  Again, under a broad range of valuation and margin assumptions we see the following:

MSCI United Kingdom 10-Year Return Estimation (5.5% Nominal Revenue Growth, 3.95% Annual Dividend Return, Various Margin and P/E Scenarios)

	10x	12x	14x	16x	18x
4.0%	0.8%	2.6%	4.1%	5.5%	6.7%
5.0%	3.0%	4.8%	6.4%	7.8%	9.0%
6.0%	4.8%	6.7%	8.3%	9.7%	10.9%
7.0%	6.4%	8.3%	9.9%	11.3%	12.6%
8.0%	7.8%	9.7%	11.3%	12.8%	14.0%

MSCI Europe (ex-UK) 10-Year Return Estimation (5.0% Nominal Revenue Growth, 3.71% Annual Dividend Return, Various Margin and P/E Scenarios)

	10x	12x	14x	16x	18x
3.5%	-0.2%	1.6%	3.1%	4.4%	5.6%
4.5%	2.2%	4.1%	5.6%	7.0%	8.2%
5.5%	4.2%	6.1%	7.7%	9.1%	10.3%
6.5%	5.9%	7.8%	9.4%	10.8%	12.1%
7.5%	7.4%	9.3%	11.0%	12.4%	13.7%

My conclusion is that long-term returns from the major developed equity markets are quite likely to remain in single digits -- and below 5% in both the US and Japan.  This realization, combined with those in Part 1 (which looked at fixed income markets) is that most plan sponsors will have great difficulty achieving their projected return assumptions, even under the most optimistic of market conditions.  Obviously a new perspective on managing funds is called for.  In coming posts, I will make some suggestions.


Sources Used: Bloomberg, Zack's Research System, Bureau of Economic Analysis, MSCI Barra, Brett Gallagher

Brace Yourself for Mediocre Returns, Part 1 of 2

While Wall Street analysts debate the next market turn, far too little effort is being put into understanding the longer-term outcomes likely from various asset classes.  Though this is a more precise and, arguably more important, exercise than the one they choose to pursue, it remains a neglected area of research.  The bad news is that even under the most optimistic default and recovery scenarios, returns from nearly every fixed income segment will barely breach 4% in the coming decade.  Investment-grade segments will struggle to return to reach a “3-handle”.  Equity returns will be better, but that’s a relative comparison, and returns from most developed equity markets will struggle to crack 5%, with European markets faring somewhat better.  

In my previous posting, I identified a little talked about risk to corporate earnings – the substantial prop to margins provided by the Fed-created low interest rate environment.  While it is important to understand that this risk exists and its magnitude, it does little to identify when the risk becomes a market issue.  It is in this regard, Investors and Wall Street Analysts spend untold hours and countless dollars in their efforts to forecast short-term market returns.  Yet in spite of these efforts, in nearly 30 years in this industry, I have yet to meet anyone who has been able to do this successfully and consistently – this author included.  At the same time, I have seen more than a handful of practitioners who have been able to fairly accurately determine long-term returns from various fixed income and equity markets.  It is ironic then that despite these long-term forecasts being both more accurate and ultimately more important to investors such as endowments, foundations and corporate pension committees, greater efforts continue to be devoted to analysis based on short term market twists and turns.

 

This posting and the next are for those willing to look beyond the coming quarter.  Using a model I originally developed in the late 1990’s, I provide what I believe to be reasonably accurate return projections for fixed income and global equity market over the coming decade, along with the methodology for doing so.  Since its introduction, this approach has quite accurately called market outcomes.

Let’s start with fixed income markets.  As you know, a bond is a fairly simple instrument with returns accruing to just four factors: the price paid, the coupon payments received, the reinvestment of those coupons and the ultimate return of principal.  Taking each in turn, we know the price paid.  We also know the coupon payment as it is contractual in nature.  The reinvestment return of these coupons is unknown; however, as I will demonstrate below, even an immediate, radical move in interest rates will not dramatically change the overall return of a bond over its lifetime.  Finally, while return of principal to a single bond may be uncertain, when looking at the broader market of bonds of similar ratings, historical experience can provide a reasonable guide as to default and recovery rates.  Putting these together, estimating long-term bond returns is a very straight forward process.

Let’s use ten-year US Treasury notes as an example.  At July 21^st, you could buy a ten-year government security with a maturity of May 15, 2023 for a price of $93.64.  That note will pay a semi-annual coupon at an annual rate of 1.75%.  At maturity, an investor will receive $100 and along the way, twice yearly coupon payments of $0.875 (per $100 value).  While we do not know the rate at which those coupons will be reinvested, even if we assume rates rise by 500 basis points before the first coupon payment is received (to 7.48% across all maturities), the total annualized return from this note will rise only to 2.96% over the ten year period.  Conversely, if rates fell to zero and an investor received no return at all on the coupons, the ten year total annualized return on this note falls only to 2.29%.  Thus, assuming no default, one can not realistically expect anything other than a return of between 2.29% and 2.96% from buying a ten-year US government note today.  Another way of looking at this is, assuming no risk of default, the best approximation of the long-term return on a bond is probably just its current yield (on the UST, currently 2.48%).

Looking at other developed government bond markets (G-7 plus Australia and Spain), we note the 10-year yields between 0.78% (Japan) and 4.60% (Spain).  Assuming no risk of default, these again are the best estimate for ten-year local currency returns. 

Source: Bloomberg

Of course, given the recent experience of Greece and on-going concern across the Eurozone, zero chance of default might not be the best assumption.  If one wanted to insure themselves against default risk, we can look to the Credit Default Swap market to gauge the costs.  Higher yielding markets such as Spain and Italy currently have annual “insurance” costs of 3.06% and 3.08%, respectively.  Perceived “safe” markets like the US and Germany have lower insurance costs of 0.41% and 0.65%, respectively.  Calculating the “net” return with insurance, we see an expectation for ten-year returns between 2.90% (Australia) at the high end and -0.46% (Japan) at the low end.

Government markets are not the only fixed income game in town.  Lower rated corporate credits, mortgage securities and the like broaden an investor’s opportunity set.  Still, like the sovereign bond markets, the current yield on these instruments, less an assumed default and recovery rate, makes for the best long-term expectations of their likely returns.  However, since default and recovery rates are uncertain, it is best to examine these markets using scenario analysis, tweaking each of these two variables.

While there are many segments within the broader fixed income universe, for the purposes of this posting, I have chosen to project returns for US High Yield, European High Yield, Emerging Market Foreign-Pay Sovereign and US Investment Grade segments – all fairly liquid markets.  Current Yields and Spreads are shown below.

	US High Yield	Euro High Yield	EM Sovereign	US Inv Grade
Current Spread	4.45	5.28	5.06	2.05
Historic Spread	5.24	6.42	4.30	1.95
Current Yield	6.01	5.85	7.66	3.87

Source: BofA Merrill Lynch, Brett Gallagher Calculations

Once again, assuming no default, Current Yield is our best guess at the long-term return from the various fixed income segments.  However, as there is some realistic level of default expected in each of these riskier pools, building a sensitivity analysis around the historic default level and recovery rates makes sense and is detailed in the tables below. 

For this analysis, I have turned to data gathered by Moody’s Investors Service which examines cumulative 10-year default percentages beginning annually in 1970.  I then convert this cumulative figure into an annual one and plug the median default experience (noted by red font), the worst 10-year default experience, the best 10-year default experience and the 25^th and 75^th percentile default experience.  Because of the longer history of the US data, I use that experience for other speculative markets as well (note: using a common data set with an inception date of 1983, European High Yield and EM Sovereign Debt actually have lower default rates than the US Universe over the common period – in the case of sovereign debt, about half that of US Corporates, though the range of outcomes is also wider). 

Default rates are calculated using Moody’s study of Cumulative 10-Year default rates over the period 1970 to 2010.  Following the cumulative default outcomes, in parenthesis, I show the annual equivalent default that results in the cumulative figure and that is used in the sensitivity tables below.

	Baa-Rated	US, Euro, EM Sovereign
Worst Case	10.34% (1.10%)	43.60% (5.65%)
25th Percentile	5.87% (0.61%)	38.53% (4.80%)
Median	4.74% (0.50%)	33.15% (4.00%)
75th Percentile	3.76% (0.38%)	19.88% (2.20%)
Best Case	1.16% (0.11%)	8.23% (0.85%)

Source: Moody’s, Brett Gallagher

* Users familiar with Moody’s data may note that my model default assumptions, when converted to annual rates, are lower than the annual average default rates over the period.  As certain outsized years have the effect of distorting the overall calculation of “average” and, as we are looking at a 10-year horizon, I feel the cumulative data, converted to an annualized figure, is more relevant.

 Using a wide range of default and recovery assumptions, we are able to construct a narrow range of likely outcomes for nearly any fixed income segment we desire.  While the returns due to risk assets appear relatively attractive when compared with developed sovereign markets, the range of returns are far below historic experience and most investors assumed return assumptions.

US High Yield Debt – Current Yield 6.01%, Median 33.1% 10-year Cumulative Default

                                       

		Annualized Default Rates
Recovery Rate		0.85%	2.20%	4.00%	4.80%	5.65%
	20.0%	5.31%	4.43%	3.30%	2.83%	2.34%
	25.0%	5.34%	4.50%	3.45%	3.00%	2.54%
	30.0%	5.37%	4.58%	3.59%	3.18%	2.75%
	35.0%	5.40%	4.66%	3.74%	3.35%	2.95%
	40.0%	5.43%	4.73%	3.88%	3.52%	3.15%
	45.0%	5.46%	4.81%	4.01%	3.68%	3.35%
	50.0%	5.49%	4.89%	4.15%	3.85%	3.54%

European High Yield Debt – Current Yield 5.85%, Median 33.1% 10-year Cumulative Default

                                             

		Annualized Default Rates
Recovery Rate		0.85%	2.20%	4.00%	4.80%	5.65%
	20.0%	5.16%	4.27%	3.14%	2.67%	2.17%
	25.0%	5.19%	4.35%	3.29%	2.84%	2.38%
	30.0%	5.22%	4.43%	3.44%	3.02%	2.59%
	35.0%	5.25%	4.50%	3.58%	3.19%	2.79%
	40.0%	5.28%	4.58%	3.72%	3.36%	2.99%
	45.0%	5.31%	4.66%	3.86%	3.53%	3.19%
	50.0%	5.34%	4.73%	4.00%	3.69%	3.39%

US Investment Grade (BBB) – Current Yield 3.87%, Median 4.7% 10-year Cumulative Default

                                              

		Annualized Default Rates
Recovery Rate		0.11%	0.38%	0.50%	0.61%	1.10%
	20.0%	3.76%	3.57%	3.48%	3.40%	3.06%
	25.0%	3.77%	3.58%	3.50%	3.43%	3.10%
	30.0%	3.77%	3.60%	3.52%	3.45%	3.14%
	35.0%	3.77%	3.61%	3.54%	3.47%	3.18%
	40.0%	3.78%	3.62%	3.56%	3.50%	3.23%
	45.0%	3.78%	3.64%	3.58%	3.52%	3.27%
	50.0%	3.79%	3.65%	3.60%	3.54%	3.31%

EM Sovereign (USD Pay) – Current Yield 7.66%, Median 33.1% 10-year Cumulative Default

                                             

		Annualized Default Rates
Recovery Rate		0.85%	2.20%	4.00%	4.80%	5.65%
	20.0%	6.85%	6.00%	4.92%	4.46%	3.98%
	25.0%	6.88%	6.07%	5.05%	4.62%	4.18%
	30.0%	6.91%	6.14%	5.19%	4.78%	4.37%
	35.0%	6.93%	6.21%	5.32%	4.94%	4.55%
	40.0%	6.96%	6.29%	5.45%	5.10%	4.74%
	45.0%	6.99%	6.36%	5.57%	5.25%	4.92%
	50.0%	7.02%	6.43%	5.70%	5.40%	5.10%

In my next post, I turn to global equity markets.

The Profitability Illusion

The current near-record level profit margins of the S&P 500 are largely an illusion, created solely by the fact that interest costs have fallen precipitously, even as overall debt levels have increased.  Operating profitability, is actually below average.  As the Fed’s Quantitative Easing program is unwound, earnings are at significant risk

Current profit margins for S&P 500 companies remain near historic highs even as the broader economy struggles and real income growth remains anemic.  The stock market trades near record levels supported, if not by fundamentals, by promises of the Fed to hold interest rates near historic lows.  Today though, the certainty of those promises is being discussed with potentially very negative consequences for US and Foreign Markets.

Market bulls point to high profitability and supportive market action as well as benign valuation as reason for their continued positive stance.  Indeed, market participants are by many measures, as bullish as ever (hedge fund net longs, investor sentiment measures).

However, analysts, like myself, who believe that margins tend to be cyclical in nature, caution that today’s high margins are a reason for restraint, not celebration.  Traditional valuation metrics like P/E ratios, tend to understate the valuation of markets when margins are well above average, as they are today, leaving open to question whether the factors supporting the market are capable of remaining in place for an extended period.

Bulls will counter that we have witnessed a permanent shift upward in margins given the now global nature of production and the ability of corporations to manage costs better than ever by using offshore operations when beneficial.  This same argument is often cited when explaining why US personal income growth remains anemic.  While on the surface this is a believable narrative, the data does not back it up.

When margins are decomposed into their component parts:

• ·         operational factors (sales less the direct costs of production)
• ·         tax factors (the percentage of sales one forfeits in taxes) 
• ·         financing factors (amounts paid due to corporate financing decisions), and
• ·         extra-ordinary items (one-off items, not likely to be recurring in nature)

it becomes obvious that the historic profitability of the S&P 500 today relies solely on the fact that interest costs have fallen precipitously during the Fed’s period of QE even as overall debt levels have increased.

Current net margins are quite high by historical standards (8.04% versus the 15-year average 6.55%).  However, “operational margins” (the profitability of a company apart from their taxes and financing decisions) are now actually below average – so much for the benefits of global production.  The reason for the discrepancy between margins as generally discussed and operational factors has to do with the very low level of interest expense (1.78% of S&P 500 sales compared to an average of 3.88%), even though overall leverage (debt as % assets) has risen to 14.2% from the long-term average of 11.5% (Averages use year-end figures calculated from Dec 1998 through Dec 2012).

The charts which follow demonstrate this dynamic quite clearly.  After a bump during the period 2005 – 2007, interest expenses have fallen dramatically in spite of the fact that debt levels climbed (most precipitously in 2009).  To measure leverage, I have chosen to show both Total Debt to Asset as well as Net Debt to Asset measures.  It is my belief that net debt better hints at corporate vulnerability to leverage as it takes into account “tactical” debt issuance where retained cash can, theoretically, be used to immediately reduce leverage should borrowing costs reverse).

The chart below shows “operational margin” levels since 1998.  Current readings are slightly below average.  Should interest costs rise and encroach on overall business profitability, it is net margins that will have to suffer disproportionately.

Sources for all exhibits: Brett Gallagher, Zack’s Investment Research

Two conclusions can be drawn from the above.  First, given the low level of interest rates, further progress in margin enhancement via lowering interest expense without paying down debt would seem limited and operational metrics must improve if current margins are to be sustained.

Secondly, should rates reverse their downward trend, interest costs could have the opposite effect on profitability as financing costs rise dramatically.  If interest expenses revert to their historic average, net margins would fall below 6% (all else equal, this results in a 25% earnings decline from today’s levels).

IN CONCLUSION, assuming continued sluggishness in economic (and, hence sales) growth, high levels of leverage and a bottoming of interest rates, maintaining margins above the norm is unlikely and reversion to mean becomes a more likely outcome than a secularly higher level of profitability.  In such an environment, earnings are vulnerable as are P/E multiples, meaning equities themselves are at risk. 

In the next two postings to this blog, I will provide long-term return assumptions for US, UK, Continental European and Japanese equities (under a range of margin and P/E assumptions) as well as a variety of government and corporate bond markets using a proven valuation methodology.  The results will have significant implications for plan sponsors and other investors.