Thursday, May 7, 2015

Equities always earn more than treasuries.

Source: Shiller Annual Data
In liquid, transparent markets, we can track total returns of a number of assets.  Here is a comparison of real total returns of stocks, 10 year bonds, and 1 year notes in the US since 1950.  This combines capital gains or losses in a given year with dividend or coupon payments, adjusted for inflation.  And, this gives the typical range of returns.  The higher the returns you get, the more volatility you have to accept.  This is clear, visually, in the graph, and the chart of averages and standard deviations confirms it.

Corporate returns are based on Nonfinancial Corporations, Net Worth at
Historic Cost, Market Value of Equities, Profit after Tax (w/o CC & inv. adj.),
Credit Market Instruments, and Interest Paid.
But what if we just look at income?  For equities, this would be profit after tax, for bonds and debt this would be the yield, or an estimate of effective yield from interest expense/total debt outstanding.  Here is what it looks like in nominal terms.

The nominal comparison is uninformative.  Debt is generally nominal, so the face value remains fixed and the interest payment includes an inflation premium.  Equity is basically a real security, because the earning power of firms in the aggregate, over time, will rise with inflation.

As I have pointed out before, returns on equities are surprisingly level over time.  Here we can see some temporary fluctuations in temporal income levels through the business cycle, but over time, equities provide real returns of around 8%, which includes the 6-7% in immediate earnings plus growth expectations that tend to be slightly higher than expected inflation, providing a small capital gain premium on top of immediate earnings.  Some of the high equity returns in the 1970s must be related to macro-uncertainty due to high inflation.  And, because equity values were so low, leverage in market value terms was very high, so this could justify a somewhat higher return on equity.  But, that is a bit of a circular argument, and I don't think it can explain such an aberration.  Maybe a combination of the tax effect of high inflation, uncertainty, and the de facto higher leverage, cumulatively, can explain it.  Please let me know in the comments if there has been any academic writing on that topic.  The extremely low level of equity capital in the 1970s and the high returns to equity is a mystery to me, and I think it is an issue that is underappreciated.

We tend to think of "Wall Street" in terms of share prices, but earnings is where value comes from.  If asset prices rise relative to earnings, that is simply a transfer between future asset holders and past asset holders.  A higher price means a lower forward yield.  As we can see in the chart above, it would be quite accurate to say that equity buyers never had it better than during the Carter administration, and equity holders saw returns on investment cut by 2/3 after Reagan took office.

But, back to the original topic.  In order to really compare these asset classes, we need to adjust for inflation to report these returns in real terms.  This is trickier than it seems.  For bonds, it's easy enough.  Subtract inflation from total interest.  While the bonds were earning that interest, the face value of the principal was declining due to inflation.

At first glance, equity returns are already in real terms.  And they basically look like a real return in the graph, except for the aberration in the 1970s.  The "principal" of firms in aggregate should basically rise with inflation, so there is no need to earn an extra inflation premium.  But, net profit has had interest expense subtracted from it.  And, that interest expense had both a real component and an inflation premium component.  The inflation component was a premium paid to creditors to make up for the fact that their principal is being eaten away by inflation.  In effect, in real terms, the inflation premium of interest expense is a capital purchase by equity holders to capture a larger portion of the firm's assets.

So, while the inflation premium needs to be subtracted from the nominal yield on corporate debt in order to arrive at a real return, it actually needs to be added to net profit to arrive at the real return to equity holders.  While the adjustment to debt returns can be estimated simply by subtracting inflation from the yield, in order to make this adjustment to equity, we need to separate interest expense into an inflation expense and a real expense, and add the inflation-related interest dollars back to net profits.  For a firm with no debt, this inflation premium effect would have no effect on real equity returns.

I am a little surprised by the outcome here.  I expected equities to always out earn debt.  They do basically always out earn treasuries.  (This would especially be true of short term treasuries.)  But, since the mid-1980s, corporate debt has captured a higher premium, so that, in terms of earnings, corporate bonds earned a higher return than equities for most of the past 30 years.

Now, I could get more complicated.  To be thorough, I would need to account for defaults, inflows & outflows.  And, we should probably credit equity holders for the added benefit of future growth on their eventual returns.  But, what originally drew me into this post was thinking about international capital flows.  Ricardo Hausmann and Federico Sturzenegger made an argument that is similar to one that I have made, that the trade deficit is basically financed by the large amount of foreign equity that Americans own.  Foreigners own assets in the US with a higher historic cost, but they consistently earn less.  This is a perfectly sustainable situation.  It is mutually beneficial.  In fact, I think it is a great example of a beautiful emergent economic order.

I see pushback on their argument that, in part, argues that Americans can't expect to earn excess returns without taking on excess risk.  But that argument is based on total returns (the first graph above).  The measures of international capital flows that fund the trade deficit are based on earnings, not on total returns.  As we can see, it is perfectly normal for equity to out earn debt consistently over time.  If we marked international assets to market and accounted for capital gains and losses in the international capital flows, we would probably get a graph like the first one above.  American investors are taking on more risk.  It just doesn't show up in flows, partly because measuring it would be impractical.

I will probably get into that topic on a future post.

In the meantime, I think this issue of earnings stability is interesting.  The fact of the matter is that aggregate earnings to equity are not particularly unstable.  So, why are equities so volatile?

This is usually presented as an issue of fickleness - of greed and fear and irrational herds.  (God, how I wish in finance we could get rid of attribution error.)  But, think about bonds.  Cash flows are stable.  The only uncertainty with a bond is the discount rate, which, depending on how one frames the issue, means that the market value of the bond can change over time, or alternatively, that, on a nominal bond, the cash flows will not have the same present value that we presumed they would when we bought the bond.  Bond prices move inversely to yields.

But, equity holders own the residual risk.  So, while they also have some risk associated with the discount rate, most of their risk is in the cash flows themselves.  First, from a change in earnings in real time, and second from a change in expected growth rates of future earnings.  So, when the "yield" in equities moves down (actual earnings decline) the prices of those equities move down with it, and the uncertainty of a business cycle shock will probably mean that growth expectations also decline, further pulling the price down.

With bonds, prices and cash flows naturally stabilize total returns, but with equities, prices and cash flows create a mutual effect on total returns.  This is a bit ironic, because liquidity clearly has a strong positive effect on the value of an individual corporate equity.  Yet, the transparent markets that create that liquidity create cyclical market-wide volatility in total returns that justifies a risk premium in equities that would presumably seem unnecessary if we viewed equities simply through an earnings framework, without the volatility in principal that is made visible by those same liquid markets.

PS (added): Here is a table with average real returns and standard deviations for the four series.  If we base equity returns on market price, then returns and volatility follow a typical pattern.  But, average equity returns based on historic cost are similar to returns based on market cap, but with much lower volatility.  Based on historic cost, equities earn more than corporate bonds with less risk and they earn so much more than treasuries that the small amount of extra risk is not material.  The risk in equities comes from the strong force of changing expectations more than from changing yields.

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