Last week, I read a paper called "How the Wealth Was Won: Factor Shares as Market Fundamentals." For a slightly wonky student of the markets like me, this paper is the equivalent of a horror movie.
It's a rather technical paper, and I won't bore you with all the details. But for those who'd like to really dive in to all the math and details, the paper can be found here.
This paper explained why the profit margin contraction I wrote about last week is a long-term problem for investors. Data in the paper confirmed my view that the future for investors is much different than what investors have come to believe is normal based on their experience of the past few decades.
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I'm simplifying, but, in the paper, the authors decompose the source of market returns since 1959. They then split the data in half and note that stocks delivered an average annual return of 4.5% from 1959 to 1988 while returns from 1989 to 2017 averaged 8.4% a year. Clearly, returns in the second half of the timeframe were much larger than gains in the first half.
The authors looked at the causes of this difference.
One reason for the higher gains in the latter period was a change in how investors felt about the stock market.
In the 1960s, investors still remembered the Great Depression. Their risk tolerance was based, in part, on that experience. As a result, they were not as enthusiastic about stocks as investors were in the 1990s. This means there was a change in the risk premium over the test period.
In practice, this meant that average fundamental metrics like price-to-earnings (P/E) ratios increased. That explains part of the change in stock market returns.
Another factor explaining part of the returns in each time period is the change in interest rates. As rates drop, stocks should increase in value. The trend in long-term interest rates is shown in the chart below.
The increase in rates in the first half of the test period detracts from stock market returns while the extended decline in rates since 1981 helps to increase returns.
These are relatively minor factors in returns. I created a table to show how each factor affected returns.
In the earlier period, the primary factor driving stock returns was economic growth, which explains 92% of the market's returns. In the second period, the most important factor was what the authors described as a trend "that reallocated rents away from workers and toward shareholders."
This is the kind of conclusion that keeps me awake at night. Essentially, the stock market's success over the past few decades was a one-time gain that cannot contribute to future returns.(OK, I'll admit I used academic terms to sidestep the controversial topic of economic inequality. The data supports the widespread belief that companies are profiting by squeezing labor costs. This trend led to the record high profit margins that we've seen in the past few years. Those higher margins made stocks more valuable, and that trend is now, most likely, nearing its end.)
- We cannot expect reallocated rents to deliver significant gains to investors.
- Given the reality that interest rates are at historic lows, the change in interest rates cannot push stock prices significantly higher.
- With P/E ratios and other fundamental measures at historic highs, there is little likelihood that a change in the risk premium will lead to high stock returns.
What does that leave us with? It means we we'll have to hope stock market returns will come from economic growth. But economic growth right now is slow and with the other factors potentially dragging returns down, so it is unlikely the next three decades will be similar to the past three decades.
Action To Take
To be clear, that's the bad news. Investors should expect low returns for the next few decades.
The good news is that it doesn't have to matter. With actively managed short-term strategies, we can attain the kind of returns investors have come to expect. That's important to remember -- the markets are changing, and we need to use strategies that adapt to the markets as they are instead of hoping markets will be kind to them.
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(This article originally appeared on StreetAuthority.com.)