Submitted by Eric Peters, CIO of One River Asset Management
We were playing the game called Institutional Investor.
Winners develop an equation to produce +7.5% returns in perpetuity. All other players declare insolvency.
Beginners play backwards through time, everyone wins, participation trophies abound. They simply average long-term historical equity and bond returns, combine them in any ratio, and can’t help but hit +7.5%.
The advanced game is played in real time, requiring you to look forward. Your bonds pay exactly +1.77% each year for the coming 10yrs.
What of stocks? The S&P 500 Shiller Price-to-Earnings Ratio is 30.2 which implies a -2% compound annual return over the coming 8yrs to return the ratio to its 17.0 mean. But not all things return to mean.
If the Shiller P/E is 50% above mean in 8yrs, it implies a nearly +3% annualized S&P 500 return. And if it falls 50% below mean, stocks annualize at roughly -10% for the coming 8yrs.
There is no mathematical equation using even the most optimistic of those returns which produces +7.5%, even playing the leveraged private equity game.
Of course, it’s possible a new bull market has begun. But in 150yrs, only secular bear markets have started with the Shiller P/E above 30 (secular bulls all began with the Shiller P/E between 5-10).
The thoughtful guys at GMO estimate the following 7yr forward annualized real returns: US large cap equity -3.9%, US small caps -1.0%, Int’l large caps -0.1%, Int’l small caps +1.7%, EM equity +4.7%, EM value equity +9.3%, US bonds -2.2%, Int’l bonds (hedged) -3.9%, EM debt -0.1%, US TIPS -1.7%, US cash +0.1%.
The only equation using GMO estimates that gets you to +7.5% includes a 75% allocation to EM value equity - and that move is strictly prohibited in the game of Institutional Investor.
In fact, playing the game forward, the only equations that work include heavy allocations to aggressive asset allocators, activist investors, absolute-return relative value strategies, volatility trading, and trend following.
Or else they contain an ill-defined ‘hope’ function.