Expected Returns
*NEW*
Has the Fed
lost control over interest rates?, by Richard Duncan, Hong Kong based economist,
June 20, 2005. From an informal source. This paper puts the interest
rate on governments bonds in a setting of the U.S. current account deficit –
which creates foreign central bank demand for U.S. government securities - against
the new supply of U.S. government securities resulting from the increase in government
and agency debt. Since the second quarter of 2004, the current account deficit has
exceeded new Treasury issues by a widening margin - indeed, at latest count by some
50%. The significance of this development is in what it suggests as to Fed control
over the level and even the direction of interest rates – unless the budget deficit
grows much larger and much faster than currently projected. The only solution would
be for the U.S. to adopt an explicit Weak Dollar Policy, which would pose a serious
threat to Asian economic growth, among other unhappy things.
The
Information Content of Share Repurchase Programs, by Gustavo Grullon and Roni
Michaely, Journal of Finance, April 2004. This carefully
composed paper has some surprises. Announcements of share repurchase programs
are not followed by an increase in operating performance nor is there any
indication that they are a signal of management optimism about future
earnings. The preponderance of these programs are associated with excess cash
flow, expectations of reduced reinvestment opportunities, and efforts to avoid
agency risk. The result of the purchases is a reduction in systematic risk.
Well worth reading.
Equities,
earnings, and equity valuation: A crisis of confidence, by Robert Arnott, The
Journal of Portfolio Management¸ Spring 2003. As a result of the
accounting games of recent years, the true earnings of the leading market
averages never reached the levels reported in 1999 and 2000. As a result,
the launching pad for the recovery in earnings has been significantly
overstated. Our society is overly tolerant of dishonesty and corrupt behavior,
but investors must come to understand what kind of earnings they are paying
for and to demand a credibility premium as well as a risk premium when the
invest in equity securities in this environment.
Expected
returns on stocks and bonds, by Atti Illmanen.
Estimating the stock/bond risk premium, by Lacy Hunt and David Hoisington.
Both of these articles appear in The Journal of Portfolio Management
for Winter 2003. Together, these two articles are the best papers yet
on the critically important question of what the expected risk premium
on equities is likely to be in the years ahead. Both conclude that
it will be below the long-term average in large part because the expected
return on equities is a single-digit number, nearer 5% than 10%. The
Illmanen article is broader,a more thorough, and more balanced analysis
than Hunt-Hoisington’s bearish presentation, but both are must
reading. Illmanen comes down in the end on the same side as Bernstein-Arnott,
Feinman (see just below), and Hunt-Hoisington.
Asset
returns in the long run, by Joshua Feinman, The Journal of Investing,
Fall 2002. Feinman conducts a meticulous
analysis of the process of developing expected returns and estimating
the equity risk premium. Although more optimistic in its conclusion
that the article I c/o-authored with Robert Arnott in the March-April
2002 issue of The Financial Analysts Journal, Feinman’s excellent
work is in much the same spirit.
The
equity premium, by Eugene Fama and Kenneth French, The Journal of
Finance, April 2002. This authoritative analysis builds
from expected rates of capital gain based on dividend and earnings
growth data. Fama and French agree with Nordhaus. The authors argue
that the average stock return over the last fifty years was a lot higher
than expected and, therefore, a high proportion of the realized excess
return over cash was due to shocks, not fundamental forces. In fact, “the
dividend and earnings growth estimates of the equity premium for 1951
to 2000 are closer to the true expected value.” Important stuff.
Stock
returns in the 1990s: Implications for the future, by Charles Jones
and Jack Wilson, The Journal of
Private Portfolio
Management, Spring 2000. I found this relatively old article languishing
in a file the other day and decided to reread it. The effort was worthwhile.
These authors are experts in collecting and interpreting historical
market data. The article provides two tables, one with geometric mean
returns from common stocks for holding periods of one to ten years
for each year from 1920 to 1998. The second table shows estimated probabilities,
based on these data, for receiving a specified return, or greater,
for holding periods from one year to forty years. The paper has many
interesting conclusions, not the least of which is the probability
of only 3%-4% that the years like 1995-1998 could recur. Here is another:
there is almost a 40% chance of a 5% return or less for any particular
single year, whether the returns immediately preceding have been good
or bad. For a holding period as long as 25 years, there is almost a
one in four chance of earning a nominal return of 8% or less. Finally, “[T]here
is very little chance that the Dow will reach 36,000 in the next few
years.”
