Links worth investing in : A special - Investing for the long term, the debate

Something a little different. We dig into a video debate between finance titans about what makes sense for investors over the long term

I usually list several links and factoids in my Friday letters, but this week, we have something slightly different. Earlier this week, I sat through a series of online presentations organised by the CFA Institute, the main academic body for financial analysts.

I can already sense eyes glazing over amongst some readers, but the discussion is actually supremely important as it explains why so many of us invest in equities, shares, and stocks.

The core case for equities – stocks and shares – is that over the long run (ten or more years) equities handsomely beat bonds and cash. Right? Up until recently that was the consensus.

Financial historians and economists such as Jeremy Siegel in the US or our very own Elroy Dimson, august professors, have peered back into history and looked at the data sets and said that the consensus is right – it has been a triumph of the equity optimists ! What happens if that is not true??

Cue the CFA virtual discussion between a bunch of older, hugely qualified men who’ve spent hundreds of years between them researching historical data and musing on what works on Wall Street – and what doesn’t.

Of course, you can view the whole debate and individual presentations HERE.

I recommend spending a couple of hours listening to it, but then again, it is also a bit pointy ‘heady’ in a nerdish sense and probably best reserved for weird financial history types like me.

It's also worth setting a context. Jeremy Siegel, an American professor, popularised the concept of stocks for the long run. He dug around in the data sets, compared returns from stocks (including dividends) with bonds over more than a hundred years, and then suggested that equities produced a better return, which justified what’s called an equity premium, i.e. an extra return from taking the risk of investing in volatile equities. This equity premium is usually between 2 and 5% per annum on average (over risk-free cash).

In simple terms, Siegel made the case in the 90s that stocks are the best long-term investment. Of course, off years and immense volatility are always inevitable, but according to the theory, Stocks will outperform bonds when examined over long time horizons. This thesis serves as a foundation to modern finance, portfolio theory, how analysts construct portfolios, and allocate assets.

These conclusions were echoed by other economists such as Roger Ibbotson, Professor in the Practice Emeritus of Finance at Yale School of Management. Another leading academic is Elroy Dimson, from the UK, Professor of Finance at Cambridge Judge Business School, and co-founder and Chairman of the Centre for Endowment Asset Management – Dimson is probably most famous for his book with Paul Marsh and Mike Staunton called The Triumph of the Optimists. This took Siegel’s insights and then applied it to a vast database of global returns from equities and bonds.i.e not just US equities.

Rob Arnott has added his own tilts and ideas into the equation, pioneering a perspective that emphasises why value investing and attention to fundamentals matters over the long term – Arnott , a brilliant financial analyst is also founder of Research Affiliates, a leading asset management firm that also runs the RAFI equity indices.

The debates among these financial heavyweights are varied and informative: Does value investing matter? Should we care about dividends? How relevant are measures such as the CAPE metric (the PE metric averaged out over the business cycle) to investing? How volatile are bonds?

But in recent years, a new voice has emerged: Edward McQuarrie. Its worth quoting from his summary biography at the CFA website – “McQuarrie was Professor Emeritus at the Leavey School of Business at Santa Clara University. After retiring from Santa Clara in 2016, he pursued new research interests in financial market history and retirement income planning. Projects underway include errors of estimate in historical index returns, the fitful nature of size and value effects…”.

McQuarrie introduced new data that was not available in the early 1990s which stretched through the full extent of the 19th century in the US. Using this much bigger data set, McQuarrie endeavoured to re-examine the long-held theory about stocks in the long run. His resulting articles in the various CFA journals sparked widespread discussion throughout the investment industry.

McQuarrie’s big innovation was that he spent years digging around the historical records for stockmarkets and bonds, unearthing new data sets that started undermining the “Stocks for the Long Run” argument. In particular once you include historical data for great expanses of the 1800s, you see new patterns emerge.

He concluded that looking at the US data set over two hundred years, sometimes equities outperformed, sometimes not.

To say this is incendiary is an understatement of epic proportions. Your pension is probably built on the ideas behind Siegel’s—and Dimson and Ibbotson’s—arguments, i.e., there is an equity risk premium, and thus, it makes sense over long periods of time to invest in stocks and shares. If this was not true in the past, what does that tell us about the future?

So, that’s the context of this online debate.

Now, to the AI-generated summary of that online debate, which I thought might be fun to include - and amazingly it does seem fairly accurate.

• Enduring Relevance of Siegel's Thesis: Despite debates and challenges, Jeremy Siegel's "Stocks for the Long Run" thesis remains a foundational concept in modern finance and portfolio theory.

• Complexity of Return Prediction: While historical data and metrics like CAPE (Cyclically Adjusted Price-to-Earnings) ratio can provide insights, predicting stock returns is complex, especially in shorter time frames.

• Shift in Corporate Payout Strategies: There's a notable trend towards stock buybacks as a more flexible alternative to dividends, which impacts traditional valuation metrics and return calculations.

• Long-Term Perspective is Crucial: Valuation metrics like CAPE become more reliable predictors over longer time horizons (10-20 years) compared to shorter periods.

• Impact of Buybacks on Metrics: Stock buybacks can significantly affect earnings per share growth, even without actual company growth, complicating the interpretation of financial metrics.

• Fluctuating Equity Risk Premium: The additional return investors expect to receive for taking on the extra risk of investing in stocks (equity premium) is not constant and varies over time.

• Challenges of Mean Reversion: While mean reversion is a popular concept, it's difficult to operationalize in practice due to the uncertainty of future "mean" values.

• Global Economic Factors: Changes in global economic conditions, such as the rise of emerging markets, can impact long-term stock market returns and challenge historical assumptions.

• Importance of Multiple Perspectives: The panel discussion highlights the value of considering diverse expert opinions when analyzing complex financial topics.

• Ongoing Evolution of Financial Theory: The debate demonstrates that even well-established financial theories are subject to ongoing scrutiny and refinement as markets and economic conditions change.

OK, so with all this out of the way, let's get to the discussion. I’ve summarized some key bits from the discussion below, providing a context and also a time reference points for the discussion if you fancy seeing the great academic financial beasts of our age battling it out (in a very friendly fashion).

How useful is the CAPE ratio for investors?

Speaker 2 Rob Arnott 00:06:21

The CAPE ratio is a week predictor of one-year returns, as everyone knows. It's a mediocre predictor of five-year returns. It's a damn good predictor of 10-year returns. And it's a remarkable predictor of 20-year returns. So I think you can forecast long-term returns with some accuracy. From current valuation levels, we should reasonably expect significantly lower long-term future returns

Are buybacks (as opposed to dividends) making a big difference to long-term investment returns?

Speaker 2 Rob Arnott 00:07:30

Buybacks are overstated as a source of return because buybacks are often announced and then don't happen. So one of the things we like to look at is buybacks defined as net reduction in outstanding stock float over a rolling five-year span. And if you do that, you find that buybacks are a very real phenomenon, but their [impact] is smaller than what most people think.

Looking at current CAPE levels, US equities earnings growth and valuations look well above average. Is that a problem?

Speaker 2 Rob Arnott 00:08:47

So the CAPE earnings are far behind current earnings [ for current US equities]. And that is historically strongly predictive of mean reversion in earnings.

How reliable is the equity premium over time? How much does it fluctuate

Speaker 5 Edward McQuarrie00:14:22

The standard deviations are not stationary. The equity premium is not stationary. The equity premium comes and goes.

Speaker 5 Edward McQuarrie00:21:39

….independent of any data that I collected, [ the question is ] how non-stationary the equity premium is, even over century-long periods. 100 basis points in change in one century, 500 basis points in the other. I think it's time to stop giving weight estimates of the equity premium. I think we do the investor community a disservice on that end. I think it's time to start emphasizing how much it fluctuates.

How big is the equity premium over time in different geographies?

Speaker 6 Elroy Dimson00:16:18

There are no decent earnings figures for any countries apart from the United States if you are a long-term historian….You see there [ in global data sets] that 2.5% or so as the equity premium based on good quality data for the United Kingdom looks very similar.

When McQuarrie had a look at his more in-depth data sets, what did the data say?

Speaker 5 Edward McQuarrie00:29:26

…What does the new record show? Stocks beat bonds. {in some years and decades] bonds beat stocks. They perform about the same. … It also shows many occasions where bonds beat stocks, now as before, over decades in length. The international record likewise shows how you can lose money in stocks over 20—and 30-year holding periods. It's not just Japan after 1989.

Speaker 5 Edward McQuarrie00:33:19

…. you should pay attention to 200-year-old U.S [data set]. It replicates the international data, which U.S. investors might otherwise dismiss on grounds of American exceptionalism, and the international data replicates the 19th-century U.S. [ data set] , which you might otherwise dismiss as too old. They establish... that sometimes stocks beat bonds, other times not.

Again, how big is the equity risk premium over time?

Speaker 4 Jeremy Siegel 00:34:35

the equity risk premium is about 3.5% here (the US) on bonds and over 4% on Treasury bills going forward. You also have the period that bonds did extremely well from 1981 until just the year after the pandemic.

Speaker 4 Jeremy Siegel 00:42:14

The equity premium is pretty persistent around the world at about 3%, even though some countries have much lower rates on bonds and stocks

Speaker 6 Elroy Dimson 01:14:12

So everywhere, equities beat inflation. We also look [ in their study] to government bonds. Government bonds generally beat inflation. ….So what does the risk premium look like? For the world's portfolio, you would have got a 5.1% a year compound return for equities. Well above what you would have got on government bonds.

Speaker 6 Elroy Dimson 01:17:46

…so the risk premium [based on his study] was 3.3%. And if we look at the risk premium the way that professors of finance, that is, look at the risk premium compared to treasury bills rather than compared to the return on government bonds, the risk premium was 4.6%.

Should bond investors be worried by the recent correlation between bond prices and equity prices? Probably

Speaker4 Jeremy Siegel 00:40:08

And by the way, here's [looking at a chart] a three-year rolling correlation over the last 90 years. of stock and bond returns. You can see how it's turned up recently.

Stocks are 20 times earnings, which to me is a 5% real yield. That's a 3% equity risk premium, and that is very near the historical average.

The one constant for investing is that eventually, all asset classes mean revert i.e they fall back to their long-term averages. True ?

Speaker 2 Rob Arnott00:50:55

We should observe that long-horizon mean reversion is a very reliable force in all aspects of the capital markets, including profit margins, growth rates, valuation multiples, and returns.

Speaker 2 Rob Arnott00:55:46

When real earnings are way above their 10-year average, subsequent earnings tend to mean revert. So, the year-end 2023 level of real earnings was 67 percent above the 10-year average. That's huge, and it's in line with the all-time extremes.

Earnings do tend to mean revert. So, this would lead to a reasonable expectation that earnings growth in the coming decade would likely be a good deal slower than what we've been used to.

We also find that the Shiller PE cyclically adjusted PE ratio is a wonderful predictor of long-term real returns.

Speaker 4 Jeremy Siegel 01:06:11

I think margins and earnings are too high, and will mean revert downward. I think they'll mean revert.

What does the equity risk premium look like after McQuarrie’s new historical data is added ? Spoiler alert – not as good

Speaker 6 Elroy Dimson01:18:47

If we add in the extra data, which we've got from Ed McQuarrie's work, the equity premium shrinks to being small, we reckon mildly negative. [based on a new research paper incorporating the latest data] our estimate is that the equity premium, looking back, is of the order of about 2.5% over 223 years.

The Bottom line? There’s obviously a lot of nerdy detail in this debate but if I had a few takeaways I’d list them as follows:

- Looking at the longer US data sets, its not true that equities always beat bonds, even over many decades.

- The equity risk premium for equities is probably smaller than we have been led to think

- The current US equity valuations and earnings growth rates are well above average and are likely to mean revert

- If the CAPE measure does value as a metric, it is useful when looking at subsequent returns over 10 or even 20 years. On that basis the US equity market looks terrible value and there’s also the possibility that earnings growth might mean revert (slow down)