May 23, 2016
John P. Hussman, Ph.D.
At present, years of relentless quantitative easing by the Federal Reserve have driven equity valuations to the point where prospective 10-12 year S&P 500 total returns are just 0-2% by our estimates, while Treasury yields are also below 2% and Treasury bill yields are only a fraction of a percent. The combination brings the expected return on this portfolio mix to the lowest level in history outside of the valuation extremes of 1929, 1937, and 2000. Yet, because investors and policy-makers seem incapable of distinguishing realized past returns from expected future returns, they fail to see the danger in this situation.
DYI Quick Comment: It is required by law to post this caveat emptor (buyer beware) statement regarding financial returns: Past performance is no guarantee of future returns. The general public is excused but pension policy makers are marking their profession for negligence and incompetency.
Recall, as I detailed last week, that real "wealth" is not inherent in the price of a security, but in the stream of cash flows it delivers over time, and the value-added production that generates those cash flows. The only way for you to spend out of the paper "wealth" of an overvalued security is by selling it to someone else and letting them hold the bag. By encouraging a sense of illusory, paper wealth, all the Fed has done is to discourage saving, and by extension, real investment (which in equilibrium must be identical to saving). Because of the Fed's singular focus on punishing saving and encouraging debt-financed consumption, growth in real gross private domestic investment in the U.S. has collapsed in the past 16 years, growing at less than 1.0% annually since 2000, compared with 4.6% annually in the preceding half-century.
Put another way, the Fed has encouraged the illusion of paper wealth while simultaneously destroying the capacity of the U.S. to produce real wealth.
All of this is tied together: zero interest rate policy, speculative yield-seeking, pension under funding, financial bubbles, malinvestment, crisis, and economic stagnation. The intentional distortions created by wholly experimental monetary policy carry a great deal of responsibility for these outcomes. The global financial economy has been pushed to such reckless speculative extremes that the ability of this house of cards to survive even a quarter point increase in short-term interest rates is a subject of serious and uninterrupted debate.
To get a full sense of the level of denial here, the following argument appeared in a February brief from the National Association of State Retirement Administrators:
“Some critics of the current public pension investment return assumption levels say that current low interest rates and volatile investment markets require public pension funds to take on excessive investment risk to achieve their assumption... Although public pension funds, like other investors, experienced sub-par returns in the 2008-2009 decline in global equity markets, median public pension fund returns over a longer period exceed the assumed rates used by most plans. Specifically, the median annualized investment return for the 25-year period ended December 31, 2015 exceeds the average assumption of 7.62 percent... Over the last 25 years, a period that has included three economic recessions and four years when median public pension fund investment returns were negative, public pension funds have exceeded their assumed rates of investment return.”
National Association of State Retirement Administrators, NASRA Issue Brief, February 2016
To draw an inference about future returns using investment returns over the past 25 years is to draw a line from the depressed valuations of 1990 to the obscene valuations of today, and then extrapolate it indefinitely. The realized past returns of this period have been strong precisely because they have robbed from future expected returns. The tide will turn, as it always has in complete market cycles across history, and as investors discovered during the market collapses of 2000-2002 and 2007-2009. The erasure of realized past returns will restore reasonable prospects for future investment, as other retreats have done.
Meanwhile, keep saving, reach for umbrellas, fasten your seat belt, and brace for the consequences and eventual opportunities that the current recklessness will bring.
DYI Comments: Returns are inverse to valuations. Valuations have been pumped up for many years pushing future returns below the average 8% assumed rate of return for pensions. Pension management along with self funding pensions (401k, Roth IRA etc.) is a moving target not static. This is a difficult ordeal for pension professionals for John Q. Public this is just another reason, among many, for the dismal state for those relegated to - do it yourself pensions.
Current Shiller PE 25.64
How bad is the future under funded pension obligations including self funding plans. I don't have a dollar figure but we can get an idea as most pension (including self funding) assume an 8% return. Below is DYI's chart for 10 year estimate average annualized returns based upon dividend yield. Dividends are the compounding mechanism for future returns just as it is for bonds. Higher the yield - higher the future return, lower the yield - lower the future return. Simple....Here's the chart....
Estimated 10yr return on Stocks
A 3.5% dividend provides a 7.8% future return or close enough to most pension assumptions of 8%. How long has dividend yields been below 3.5%?
Current dividend yield 2.14%
The Fed's through their total recklessness has engineered a pension crises of biblical proportions. In my mind the Fed's are not capable of being reformed as I've been in the camp of Ron Paul for over two decades that we should end the Fed. Not only have they created a pension crises, they have embarked upon to destroy basic savings. The life blood for economic growth begins with savings once they become excessive they are used for business formation creating jobs. Also most retirees supplement their Social Security with interest from their CD's at the bank. With sub atomic low rates the elderly have had to spend the principal to make ends meet. Once the principal is used up many have had to reenter the work force (many never left do to such low rates) to maintain a reasonable living.
So far we have had eight years of sub atomic low rates with a mentality of doing what ever it takes. All this has done is to jack up leverage along with security prices but has done nothing for the real economy. The common man has been impoverished as jobs have vanished, who no longer can afford a house, nor can he invest to out run your intentional debasement of our currency.
The Fed's REAL mandate is to save the banks up to and including STEALING from the public through currency debasement. The banks in New York and London made bad bets and are bankrupt. The money center banks had their thrill with massive speculative bets and the American public (along with England) GET'S THE BILL.
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