Thursday, January 06, 2005

Risk premium and equity outperformance

As discussed previously, there are good reasons to expect that the equity risk premium will be less than 5% (its historical value over the last century) in the future. In the 19th century, stocks only outperformed bonds by 1.5%!

This is of course relevant to the current debate over privatization of social security. Below I've reproduced a figure from William Bernstein's site Efficient Frontier, which shows the probability of equity outperformance for a given value of the risk premium and an assumed historical volatility of about 17% for stocks. For example, if the risk premium is only 2% over the next 20 years, there is a 35% chance the equity portion of an individual account will actually do worse than if it were invested in treasuries.

Bernstein attributes the very different results of the 19th and 20th centuries to inflation. He claims that in the 19th century inflation was not understood to be a threat to bond returns. At the beginning of the 20th century, bond yields were 5%, which looked pretty attractive, as it was assumed to be a real rather than nominal yield. The inflation brought on by two world wars and the death of the gold standard was disastrous for bond holders. On the other hand, equity returns managed to keep pace with inflation (companies could pass increased costs on to consumers). As a consequence, investors bid up equities and devalued bonds. I still think there are obvious reasons (such as short-term volatility) for investors to demand a premium for holding equities. But a 5% equity premium is quite optimistic.

Bernstein: With hindsight we can see that the 5% stock-bond return gap in the 20th century was the result of a totally unexpected inflationary burst produced by the abandonment of hard money. You can’t abandon hard money twice, so a repeat is not possible. Though inflation might increase dramatically in the future, resulting in another high stock-bond return gap, it’s at least as likely that inflation will remain tame for the foreseeable future, producing nearly equal stock and bond returns. More importantly, we now live in a world where investors have learned to extract an inflation premium from bonds and to expect inflation protection from stocks.


Anonymous said...

Korean Shipbuilders See China's Shadow

ULSAN, South Korea - Down at the dry docks here, where workers are dwarfed by propellers larger than houses, the world's largest shipyard is now so efficient that a new $80 million vessel slips into the water every four working days.

Not content with making some of the most complex products on the world market, naval engineers for the Hyundai Heavy Industries Company are drawing up computer models to increase the size of the largest container ships by more than 25 percent, creating a supervessel that could carry 10,000 steel containers, enough freight capacity for 30 million pairs of sneakers.

Only in 2004, when South Korea exported ships with a value of $15.09 billion, did it definitively wrest from Japan the status of the world's leading shipbuilding nation.

But the South Koreans are already looking over their shoulder at China, which has embarked on a path toward becoming the largest shipbuilder by 2015. Chinese competition, which has unnerved American manufacturers, is also putting much of Asia on edge as China rapidly narrows the technological gap with higher-wage Asian neighbors.

'When you are being chased, you have to do something that the chaser cannot do,' Han Dae Yoon, chief marketing officer of Hyundai's shipbuilding unit, said of China's ambitions.


Anonymous said...

A Harvest at Peril

SÃO PAULO, Brazil - After almost a decade of rising prices and record profits, soybean farmers in Brazil, the world's second-largest soybean producer and exporter, are now bracing for tougher times.

One reason is the tumble in soybean prices, down nearly 30 percent since March, when they hit their highest level in more than 15 years. The fall came largely because of China's decision to cut back on imports and because of a bumper crop in the United States, the world's No. 1 producer and exporter.

But another big factor is Asian soy rust, a deadly crop fungus that has been ravaging plantations here since it made its way to South America three years ago. The emergence of the disease, which can destroy up to 80 percent of a crop if left untreated, has significantly raised production costs for farmers at a time when profit margins are already narrowing because of the price drop.

As a result, the rapid growth of Brazil's soy industry, which accounts for nearly half of the country's farm exports, is starting to slow, making it unlikely that it will overtake the United States in soybean production as early as next season (2005-6), as some analysts had predicted.


Anonymous said...

Doctoral Thesis Says Rich People Spend More on Conspicuous Things

LONG before Thorstein Veblen coined the term 'conspicuous consumption,' economists from Adam Smith to Karl Marx had argued that people choose to buy some goods because of what those goods reveal about their standing in society, not because of any intrinsic enjoyment they get from the purchase.

Yet conspicuous consumption remained mainly a theoretical curiosity for more than a century, with little empirical content or support. Now, Ori Heffetz, a doctoral student in economics at Princeton University, has developed the first broad-gauged index of product visibility. Sure enough, he finds in his thesis that conspicuous items make up a greater share of the consumption budget in wealthier families.

The idea of conspicuous consumption is intuitive. A Timex watch, for example, tells time about as well as a Rolex, but the particular watch you wear tells a lot about your purchasing power and personality. A major motivation for buying an extravagant watch is to signal to others that the consumer has 'made it,' a point not lost on advertisers.

In Veblen's view, the wealthy engage in conspicuous consumption to advertise their wealth. If true, such behavior can set off a wasteful rat race, in which people buy expensive products they don't particularly like only to 'keep up with the Joneses' and signal their lofty status. Because conspicuous consumption makes others feel less successful, some economists have argued that society would be better off if a high tax rate were applied to goods that are the object of conspicuous consumption.

It is unclear, however, whether conspicuous consumption is a motivation underlying the purchase of many products or just a few. Furthermore, products that are conspicuous may nonetheless be consumed for their intrinsic value, not their curb appeal.


Anonymous said...

Land Rush by Foreign Investors Divides South Africa

HIBISCUS COAST, South Africa - David Bailey is about to buy his 11th piece of property here on this country's southeast coast, fully expecting to sell it in a year for a nice profit. And why not? He has done it three times in three years, he said, clearing a tidy $200,000 along the way.

With this nation's housing prices headed toward the ionosphere, one could almost say that Mr. Bailey has captured for himself a piece of the South African dream. Except that he isn't South African. Mr. Bailey, 43, is a construction subcontractor from outside Belfast.

'Friends of ours had bought here. Property was so cheap compared to home. We decided to invest because we could see the land was getting scarce and prices were starting to move,' he said as he enjoyed an early brunch at a cafe overlooking the Indian Ocean. 'It has been excellent. The prices just keep going up.'

Let others sniff out the coastline of Spain, France or Ireland, itself the site of a property boom. Mr. Bailey sees much better prospects along the breathtaking coastline of South Africa's Eastern Cape. Hidden from the world for decades under apartheid, it has now become the object of a minor land rush by foreign investors.


Anonymous said...

When Vanguard began its S&P Index Fund on 8/31/76, the price earning ratio was below 10. The p/e ratio did not climb above 10 till 1983. At the market peak on 8/31/87, the p/e ratio was above 17. The S&P began the 1990s at a p/e above 15 and finished at a p/e above 35 if this number can be trusted. Now, we are at 20.

The Vanguard S&P Index Fund benefited by the p/e ratio going from below 10 to 20. Also, until recently dividends were far higher than they are today and I trust stock buybacks less than dividends in adding to stock market returns.

So my long term sense of the market is rather than look for a 12.4% return as the Vanguard Fund records from inception, a 7% return seems conservatively reasonable.


Anonymous said...

John Bogle has done a number of studies looking at the actual returns of mutual fund investors through the bull market years from 1982 on. The flow of money to and from funds shows the returns in fact to be most discouraging. The problem has been discipline discipline discipline, both by the investors and by active managers of funds. Of course, costs of investment are a problem as well. Investors in stock funds have fallen far far short of the S&P returns for the period. There's the trick for investors. If we expect returns to be less robust in the coming 22 years, then similar mutual fund useage will leave investors with scant gains. Giving up 2 percentage points in gains from returns of 12%, is too much. But, the same 2 percentage points from 7% returns is much much too much. Bogle argues however that investors and active fund managers give up more than 3 percentage points.

Anonymous said...

Newcomers to Energy Investments Could Make This Year's Price Swings Wild


THE jarring swings in oil prices that gave investors and traders whiplash in 2004 are not preventing new investors from rushing into oil and other energy-related commodities this year.

These investors are attracted by the promise of better returns than those offered by bonds and equities, bankers and traders say. Ultimately, the rising number of speculators could lead to even more price volatility in 2005 as they push the highs higher and the lows lower.

Speculation on oil prices is not limited to hedge funds, which were popular scapegoats for high oil prices last year. Some of the largest pension funds, insurance companies and endowments are moving more and more money into commodity indexes, which are heavily weighted in oil and gas futures. Wealthy private investors are also snapping up new oil price-related products.

"After a generation in the wilderness," the oil futures that are used to make a bet on oil prices "have become a bona fide investment," said Charles O'Donnell, who manages Lake Asset Management, a small energy fund based in London.


Anonymous said...

So, from South Africa to China the race is for resource acquisition.

Anonymous said...

November 12, 2004

Using a New Language in Africa to Save Dying Ones

NAIROBI, Kenya - Swahili speakers wishing to use a "kompyuta" - as computer is rendered in Swahili - have been out of luck when it comes to communicating in their tongue. Computers, no matter how bulky their hard drives or sophisticated their software packages, have not yet mastered Swahili or hundreds of other indigenous African languages.

But that may soon change. Across the continent, linguists are working with experts in information technology to make computers more accessible to Africans who happen not to know English, French or the other major languages that have been programmed into the world's desktops.

There are economic reasons for the outreach. Microsoft, which is working to incorporate Swahili into Microsoft Windows, Microsoft Office and other popular programs, sees a market for its software among the roughly 100 million Swahili speakers in East Africa. The same goes for Google, which last month launched, offering a Kenyan version in Swahili of the popular search engine.

But the campaign to Africanize cyberspace is not all about the bottom line. There are hundreds of languages in Africa - some spoken only by a few dozen elders - and they are dying out at an alarming rate.


Steve Hsu said...

Hmm... I bet the South African coastline is beautiful.

Regarding individual investors, there is a definite pattern of buying at the peak and selling at the troughs. It takes relentless discipline to equal the index returns.

I am very curious about what finance academics have to say about Bernstein's thesis. I had never heard anyone point out that the 19th century risk premium was so low. (If I recall from the massive Ibottson book it isn't so high for foreign markets either.)

Was the 20th century just a particularly good one for US equity investors? The future of social security may hinge on the answer!

Anne, your rough prediction of 7% SP return going forward is a 4% real return. Judging by the current TIPS yield of 2% it sounds like you are forecasting a risk premium of only 2% going forward. You can read off from the graph what that means for prob. of doing worse than treasuries.

Anonymous said...

Through the day I will think to your fine comments.

China Oil Giant Said to Weigh Making an Offer for Unocal

China's state-controlled offshore oil company is studying a possible bid for Unocal, the ninth-largest oil company in the United States, people close to the American company said yesterday.

The Chinese company, the China National Offshore Oil Corporation, or Cnooc, recently commissioned a review of Unocal's assets, the executives said, and has made a preliminary overture to Unocal to express its interest in a possible deal. Unocal, based in El Segundo, Calif., has a current market value of $11.7 billion.

The overture by Cnooc is another sign of China's intense appetite for energy resources abroad to power its fast-growing economy. China is now second only to the United States in its demand for oil, but its domestic production has been stagnant in recent years and is expected to decline in the years ahead.

Anonymous said...

China's development strategy, complete with the accumulation of dollar reserves, seems awfully intelligent to me. For a century we wondered why less developed nations did not close the gulf with the most developed. Finally this may be happening with the model set by China.


Anonymous said...

Mandela, Anti-AIDS Crusader, Says Son Died of Disease

SALT ROCK, South Africa - Nelson Mandela, who has devoted much of his life after leaving South Africa's presidency to a campaign against AIDS, said Thursday that his son had died of the disease in a Johannesburg clinic.

The son, Makgatho L. Mandela, 54, had been seriously ill for more than a month, but the nature of his ailment had not been made public before his death on Thursday.

At a news conference in the garden of his Johannesburg home, the elder Mr. Mandela said he was disclosing the cause of his son's death to focus more attention on AIDS, which is still a taboo topic among many South Africans. To keep the illness secret would wrongly imply that it is shameful, he said.

"That is why I have announced that my son has died of AIDS," he said. "Let us give publicity to H.I.V./AIDS and not hide it, because the only way to make it appear like a normal illness like TB, like cancer, is always to come out and say somebody has died because of H.I.V./AIDS, and people will stop regarding it as something extraordinary."

Mr. Mandela, 86, gave the statement surrounded by his family, including his wife, Graça Machel, and his grandchildren. Makgatho, who was a lawyer, was Mr. Mandela's only surviving son; his younger son, Thembekile, died in an auto accident in 1969, shortly after Mr. Mandela began 27 years of imprisonment as punishment for his anti-apartheid activities.


Anonymous said...

Nelson Mandela Loses a Son

Among the biggest obstacles to combating the global AIDS epidemic is the culture of silence and shame that continues to surround the disease, especially in hard-hit countries like South Africa, where the United Nations estimates that one in five adults have AIDS or are infected with H.I.V. Yesterday's announcement by Nelson Mandela that his 54-year-old son, Makgatho, had died of AIDS was an important step toward ending a taboo that keeps many people across Africa from talking openly about the disease's impact on them and their families, thereby hampering treatment and prevention efforts.


Anonymous said...

The South African coast is stunningly beautiful. I always think that South Africa could drive development for all southern Africa. But, the pragmatic leadership flexibility that Nelson Mandela and his generation developed may not be reflected in this generation's leadership. Still, the legacy is there and I would share in Mandela's hope or the hope of Nadine Gordimer.

Anonymous said...

The 10 year Treasury yields about 4.3%. This is what we will earn if we hold a note for the coming decade. The S&P dividend is about 1.5% after costs. So, the S&P must average 2.5% in capital gains over the decade to equal the 4% return of a Treasury note. The last 5 years, the S&P has lost value. I would seriously believe the S&P will gain more than 4% this coming decade. For bonds to fare better than stocks for 15 years could happen, but I find the chance small.

Anonymous said...

Yes, Anne :)

Anonymous said...

The yield on the Vanguard Inflation Protected Securites Fund is 1.2%. So, if inflation is 2.8% over the coming decade TIPS are worth holding. Remember, stock dividends and capital gains are taxed at 15%, while bond interest is taxed at our income tax rate. Will TIPS be a superior investment to the S&P over the decade? I would guess not.


Anonymous said...

Brad Setser's Web Log
« Already Conventional Wisdom? | Main

January 06, 2005
I hear the Cayman Islands are lovely this time of year
Maybe New York bankers should schedule a few visits to the branch offices down there. They sure are doing plenty of business in the Caribbean.

US banks have extended more credit to the Caymans ($568.9 billion) than to London ($457.9 billion) -- and the amount that they are lending just seems to keep growing. Lending to the Caymans has almost doubled since the end of 2001. US bank credit to the Caymans now accounts for about a 30% of all US bank credit to foreigners ...

Compare that say with the share of US bank lending to Asia before the Asian crisis: 20% (it is about 10% now).

Seriously, when the Federal Reserve worries about too much liquidity sloshing around global markets and fueling financial excesses (like really low spreads on US corporate debt, for example) they probably are looking at statistics like these. Bank credit to the Caymans is probably a pretty good proxy for bank credit to hedge funds.

Banks lend to their branch office in the Caribbean, who then lend to hedge funds. The hedge funds then buy US securities. This of course does not provide any net credit to the US: Banks lend to a foreigner (a hedge fund based offshore) and the foreigner lends the money right back to the US.

LTCM's crisis back in 1998 led banks and broker-dealers to pull back on the credit they extended to hedge funds. I hope the lessons of this crisis have not been forgotten. I suspect the New York Fed does too. The spreads on lots of risky assets have fallen back to pre-LTCM levels.

Leverage plus major global imbalances that imply large changes in the relative prices of many financial assets at some point, though no one can say when, are a potentially dangerous combination.

Posted by brad at January 6, 2005 11:48 PM

How about the relative price of the most common financial asset of all - Money?

Posted by: s at January 7, 2005 12:14 PM

"Leverage plus major global imbalances that imply large changes in the relative prices of many financial assets at some point, though no one can say when, are a potentially dangerous combination."

Worrisome, surely. Then what might the Federal Reserve do? Should short term interest rate increases be quickened? I would hope not for I find reason to worry about sluggish employment and wage and benefit levels. What might be done by the Fed? What might pension plans and private investors do to protect portfolios?

Posted by: anne at January 7, 2005 12:28 PM

The 10 year Treasury yields about 4.3%. This is what we will earn if we hold a note for the coming decade. The S&P dividend is about 1.5% after costs. So, the S&P must average 2.5% in capital gains over the decade to equal the 4% return of a Treasury note. The last 5 years, the S&P has lost value. I would seriously believe the S&P will gain more than 4% this coming decade. For bonds to fare better than stocks for 15 years could happen, but I find the chance small.

Posted by: anne at January 7, 2005 01:07 PM

yes, but stocks are a nominal instrument. you have to admit that there is a non-zero (in my mind large) probability that inflation erodes the return on bonds. I think we should hold TIPS. you get the nominal upside, without the overvaluation.

Posted by: s at January 7, 2005 01:29 PM

Game Over?
Stephen Roach

The unraveling of the Asset Economy could well be at hand. America’s Federal Reserve has finally woken up to the perils of the risk culture that its reckless accommodation has spawned. The Fed has sounded simultaneous alarms on two fronts -- inflation and excesses in asset markets. Such explicit warnings from the US monetary authority are rare and should be taken seriously. This has important implications for the interest rate outlook, as well as for the asset-dependent US economy....

Many believe that the Fed would be over-reaching its mandate by squeezing carry trades. I don’t share that view. Unlike many central banks, America’s Federal Reserve is not a one-dimensional inflation targeter. Instead, it is charged by the US Congress with promoting price stability, full employment, and sustained economic growth. To the extent that speculative excesses jeopardize the stability of the US economy, the Fed is well within its purview of addressing financial market imbalances. It did so in 1994 and belatedly again in 2000.


Anonymous said...

Steve Roach comes from the no pain-no gain approach to economic policy making. I do not find such an approach helpful, and hopefully the Fed will not. I do not think it is for the Fed to try to limit asset prices.


Anonymous said...

Obviously, I poorly copied a post :(

Anonymous said...

Enter the Chinese Dragon, Now Bearing Minicars

BEIJING - After a year in which dozens of Chinese corporations went global with their plans, the Chery Automobile Company has joined them with an ambitious gamble to become the first Chinese automaker to sell cars in the United States.

The company announced this week that beginning in 2007 it would export 250,000 cars to the United States in partnership with Visionary Vehicles, an auto import and distribution company based in New York. Visionary Vehicles said the Chery cars would be 30 percent cheaper than comparable models sold in the United States and would offer a 10-year warranty.

The plan's scope, and the company's own peculiarities, give the undertaking a faintly quixotic hue.

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