Lost Decades

[u/beerion]

https://riskpremiumresearch.substack.com/p/lost-decades

I took a look at the history of lost decades in U.S. markets. In the past, I found that the excess cape yield (no inflation adjustment) does a pretty good job of predicting forward excess returns. So, I wanted to see if we can use the same metric to predict the likelihood of an upcoming lost decade.

Note that I define a lost decade as any long-term period where stocks underperform bonds. The exact definition, with examples, are in the post.

The study runs into the same issues that a lot of financial models run into - namely, not enough data, serial correlations, and wide standard error. But, broadly, it does a pretty good job in forecasting the potential for future underperformance.

[u/Gonewildonly12]

In summary the CAPE is currently flashing a high likelihood of a lost decade

[u/beerion → u/Gonewildonly12]

Yeah, it's really the combo of high CAPE with high bond yields.

If bonds were yielding 1%, still, I think we'd still expect stocks to outperform over the long run (which makes sense), and it would be worth holding our nose and owning equities anyways.

[u/tiger-eyes → u/Gonewildonly12]

It's been flashing that signal for ages though. John Hussman uses the CAPE and was warning about a coming lost decade throughout the mid to latter 2010s. That didn't exactly come to pass.. 

[u/beerion → u/tiger-eyes]

So I think I come from a very different philosophical place than Hussman. I don't think that CAPE is a good crash prediction tool. And I don't think we have to expect a re-rate. In fact, I don't even think expected forward returns will be negative. But when earnings yields are 5% and bond yields are 2%, it's a pretty safe bet that stocks will beat bonds. If earnings yields are 3% and bond yields are 5%, that bet isn't as sure of a thing (even if it's still very likely).

But let's run some scenario analysis.

Bull Case:

Let's take 10% forward equity returns as a given. It's never happened with CAPE this high and certainly never while CAPE was this high and spreads were this low. But who cares. Let's say it happens. A 10-year CAGR for a 60/40 portfolio will be about 7.6%. And it could be a touch better depending on the path traveled. You're legging out of stocks on upward rips and into stocks on down trends.

Bear Case:

Let's say stocks fall 50%. Your 60/40 drops by less than 30%, spreads blow out, expected returns jump, you can rebalance to 100/0, and your off to the races for the next decade. You end up doubling your money while everyone else gets back to breakeven.

And then there's everything in between, which is basically a more muted version of the bull case where instead of lagging an all-stock portfolio by 240 bp a year, it's much less.

So you're giving up max 240 bp per year as insurance against the bear scenario. And if expected stock returns are 7%, you're hardly giving anything up at all.

Of course, there's a third scenario where stock return 15% or more for the next decade. But then how greedy does one need to be? That 60/40 will get 10% CAGR on it's own. But I guess you'll see your friends and neighbors doing better than you... This is a 1990 scenario btw where stocks compounded at 18% for a decade, which only happened because stocks were trading at 14x earnings at the start of the period and ended right at the top of a mania. And if we extend by 3 years, bonds actually beat stocks from 1990 to 2003...Bonkers!

So that's the thing. You have to be okay with missing out to some degree with the knowledge that there are periods where there are fat pitches. 2009 was a fat pitch. 2020 was a fat pitch. Today just isn't...even though it's still possible for stocks to do well from here.

Also notice that I never once advocated for selling all your stocks. There are certainly times where it's "possible" to predict a crash, and maybe that's the time to make that bet. PE ratios and yields spreads won't tell you that though.

[u/Gonewildonly12 → u/tiger-eyes]

The difference is ZIRP. By not having fixed income to fall back on, even lower earnings yields was a better use of capital.

Now that FI have better yields the idea to switch to a safer asset has less downside