(August 30, 2012) — Reports predicting the death of equities have been greatly exaggerated, according to Ben Inker, head of the asset allocation group at Boston-based GMO.
“In a time when investors are questioning what role equities should have in their portfolios, it is worth understanding where the returns to equities come from, and why, after a 12-year period in which US equity returns have been negative, we can still be confident that the returns will, after all, be there in the long run,” Inker wrote in a paper.
The paper — “Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns” — outlines the following five points:
1) GDP growth and stock market returns do not have any particularly obvious relationship.
2) Stock market returns can be significantly higher than GDP growth in perpetuity without leading to any economic absurdities.
3) The most plausible reason to expect a substantial equity risk premium going forward is the extremely inconvenient times that equity markets tend to lose investors’ money.
4) The only time it is rational to expect that equities will give their long-term risk premium is when the pricing of the stock market gives enough cash flow to shareholders to fund that return.
5) Disappointing returns from equity markets over a period of time should not be viewed as a signal of the “death of equities.” Such losses are necessary for overpriced equity markets to revert to sustainable levels, and are therefore a necessary condition for the long-term return to equities to be stable.
But as equity returns suffer a dismal reality in the short-term, what sectors should investors pursue? The investment environment is undergoing a “new normal” with asset allocation, according to a whitepaper by JP Morgan’s Joseph Azelby, Michael Hudgins, and Bernie McNamara, published in June. While equities have lagged over the most recent 10 years, with an annualized total return of 2.9% as of December 2011, “real assets” is one category that is fast gaining acceptance as an essential portfolio component. According to JP Morgan, the performance of global real assets bridges the gap between fixed-income and equity, noting that the asset class is characterized typically by investments in tangible “hard” assets that provide a blend of stable income, equity-like upside potential, inflation hedging, and lower volatility. In addition, the sector typically provides low correlations to the two current “traditionals”—equities and fixed income.
“These are difficult times for investors with volatile equity markets, low growth prospects in developed markets, and the threat of inflation,” McNamara told aiCIO. “With those circumstances, we’re finding that investors are looking to other solutions.”