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Earlier we posted part of a letter from GMO LLC’s Ben Inker examining the myth of the so-called Death Of Equities, and this notion posed by Bill Gross that stocks could no longer outperform GDP, as they have done in the past.Inker deals easily with the notion that stocks can’t outperform GDP by pointing out that return on equity is a totally different beast from GDP, which measures output. And that you could, for example, have very low GDP, but if investment is modest, get a good return from that. Or if GDP is normal pace, but you’re investing like crazy, you might get a poor return.
Later in the note he deals with what might be a more interesting question, which is: Why do equities seem to inherently outperform?
Inker says basically they have to in order to compensate for the occasional massive drawdowns you experience while holding equities. And that conversely, because equities are the safest form of capital for corporations (because they require no regular payments), corporations have good reason to issue it.
So why have returns to equity holders been so good over time? Is it really necessary to give a return of almost 6% real to entice investors to buy stocks? No one seems to have come up with a precise, convincing answer as to what return investors should demand from equities, but common sense suggests it should be a considerable return. This is not simply because equities are volatile – after all, a short position in equities is every bit as volatile as a long position, and they cannot both offer a return above cash – but because equities cost you money at such an inconvenient time. The worst returns to equities come in recessions (bad), ﬁnancial crises (very bad), depressions (very, very bad), and major
wars (not good at all). If you’ll forgive me for not ﬁlling in the titles of the various bad events, Exhibit 6 shows the rolling 3-year real return to the S&P 500, with shaded areas denoting the losses associated with events from the Panic of 1907 through World War I and its ensuing depression, the Great Depression, World War II, the 1970’s Oil Shocks, and on to the Global Financial Crisis. While the average return to the S&P 500 over this period was a reassuring 6.6% real, at those times when you were most at risk of losing your job, your bank account, your house, or your life, you could rely on equities to be piling on the misery.
It is only rational for equity holders to demand a decent return for taking that very unfortunate return path. Furthermore, and just as crucially, we believe it is rational for companies to be willing to pay it. For corporations, equity is the safest capital they can raise. Unlike debt, there are no mandated payments associated with it, and no need to periodically reﬁnance it. If a company is looking to ﬁnance investments with long durations and signiﬁcant potential volatility to the cash ﬂows generated, equity is the ﬁnancing choice that minimizes the risk of the company going out of business. As a business owner, it is entirely rational to be willing to pay a higher expected rate of return to such “safe” capital.
The above statements do not actually specify what the required annual rate of return to equities must be. Here, we have to use some judgment. Our estimate for this return is 5.5-6.0% real, which is in line with the long-term returns to equities in the U.S. and elsewhere, about 3% higher than our estimate for high quality ﬁxed income, and 4% above our long-term estimate for cash returns. We can’t be entirely sure we are correct, but it would be decidedly odd if equities didn’t offer a signiﬁcantly higher return than high quality ﬁxed income. It’s not simply that equities are more volatile and have greater uncertainty than ﬁxed income, but in recessions, depressions, and ﬁnancial crises, high quality ﬁxed
income tends to go up rather than down.3 Furthermore, long-duration ﬁxed income is a natural ﬁt for a number of large investors who have long-duration liabilities they are looking to match. An insurer or pension fund may well be interested in owning ﬁxed income at very low expected returns as a hedge, while no one (with the possible exception of bankruptcy lawyers) could view a long position in equities as a hedge.
So while we can’t specify the required return to equities with certainty, it makes sense that they should have a signiﬁcantly higher required return than high quality ﬁxed income.
None of this gaurantees that past rates of return will be matched in the future. It just shows that there’s a theoretical basis for what the data has shown, which is that equity does tend to outperform.
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