One of the shareholder letters we really look forward to reading is the one from Horizon Kinetics. In their recently released Q2 2018 letter Horizon Kinetics provides some interesting research and commentary on the performance of passive investing over the past 20 years. The results may surprise many investors saying:
“Let’s not forget that these roughly 6% stock returns were achieved with the support of the greatest fiscal and monetary stimulus in the history of civilization, including one of the longest stock market recoveries and one of the longest post-recession economic recoveries. What will happen without a further stimulus?”
Here is an excerpt from that letter:
Let’s not take the Wall Street investment formulas and computer modelled asset allocation software so seriously that we forget the most basic lesson of all. Investment returns are more about price (or valuation) than anything else – it’s a lot better to pay too little for a poor business than to pay too much for a good business. And price is strictly, 100%, about human behavior and demand or absence of demand.
After all, is there any other factor that exists in the universe that would impact the price of a stock, that would care about buying or selling shares? Any independently operating computer with its own capital? Anything in the non-human primate world? Extra-terrestrial beings? It seems silly to write this, but we seem to forget that when we see a well-performing stock or sector that there is nothing intrinsic about it – it simply reflects the impact of other people’s demand.
Is a certain baseball card or Beanie Baby doll intrinsically worth some given amount of money? Some websites advertise a particular Beanie Baby for sale at $16,000; others say that they don’t really change hands there, that the real price – the transaction price – is more like $7 dollars.
With every passing day, more and more of the supply of financial assets is allocated to the same global asset classes and, in turn, to the various asset class sub-sectors and, finally, channeled to the same relatively small number of sufficiently liquid securities within those sub-sectors.
That is because these choices are determined by the index classification system, and access to them is via the ETFs linked to those indexes. On an average day, the equity ETFs receive an additional $1.4 billion of inflow, which translates immediately into buy orders, and bond ETFs receive about $0.5 billion.
By the laws of human nature and markets, that persistent and undifferentiated demand has created excessive valuations and will ultimately place a limit on the future returns.
In fact, that limit might already be measurable. Some ETFs now have a 20-year track record, and a whole bunch more are closing in on it. Their records speak for themselves. First the 20-year club, all of them individual international markets. There are 17 of them, and all began on March 12, 1996. Not a single one produced as much as a 10% annual return, and only 4 of them beat a long-term Treasury.
Next are some of the major equity allocation building blocks, the S&P 500, the Russell 2000 index of smaller companies, the Nasdaq 100 rocket ships, some early factor based efforts in the form of the S&P 500 Growth and S&P 500 Value sub-sets, the major international stock index known as EAFE, which covers Europe, Asia and the Far East, and finally the major emerging markets index as well. Most of these are in the 18-year club.
Here, too, no 10% annual stock market returns that have long been presumed to be a form of manifest destiny, a virtual right owed to investors. Some of this has to do with the weighting tactics and rebalancing rules that these indexes devise.
In fact, if, 20 years ago, you decided to buy a 30-year U.S. Treasury Bond, the yield to maturity, according to the St. Louis Fed, was 5.62%. That’s pretty much the same as these major stock index returns. Moreover, that Treasury would still have 10 years remaining. And since the yield on 10-year Treasuries today is only 2.86%, that Treasury could be sold today for 123.8. That would add 1.07% to your annual return, for an all-in rate of return over 6.6%. That beats the majority of these stock indexes.
Let’s not forget that these roughly 6% stock returns were achieved with the support of the greatest fiscal and monetary stimulus in the history of civilization, including one of the longest stock market recoveries and one of the longest post-recession economic recoveries. What will happen without a further stimulus?
Just to be thorough, maybe you could have done better with some of the narrow growth industries like Technology or Tech Software or Biotech, where higher returns can presumably be cherry picked (alongside all the other people who put billions of dollars into the same instruments). You see how mutually consistent all of these different equity class returns are, with very little variability.
They don’t reflect the underlying economic attributes of the countries, industries and companies. Rather, they reflect to some great degree the common, undifferentiated inflows of cash they all receive. That might not be the only reason. This is a unique period in history, because the central banks of the world basically brought interest rates to zero; we have not had an interest rate cycle in decades.
Historically, the Federal Reserve would periodically raise rates and that would affect particular companies and industries and, certainly, the high yield bond index, but we haven’t had such an interest cycle in a long while. The companies today that are dangerously leveraged have not created the problems that would have previously developed, and they’ve actually performed exceedingly well relative to the historical experience. In any case, both possible reasons are systemic and one wants to be away from those risks.
You can read the entire Q2 2018 shareholder letter here.
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