What if the real lesson for investors studying the history of financial markets was that the future will be different from the past? Financial markets periodically undergo profound changes which bear little resemblance to what has happened before. This means that history tells us nothing other than that the future is unknowable.
Bryan Taylor, chief economist at Global Financial Data, believes we’re going through yet another of these sweeping changes. The table below summarizes the previous eras in the history of the American market up to 1792, as Taylor presented them in an interview.
The table also shows for each epoch the amount by which stocks beat bonds – the so-called equity premium. The data on stock bonuses comes from a new database compiled by Edward McQuarrie, professor emeritus at the Leavey School of Business at the University of Santa Clara (California). Data for 1982 period end in 2019.
Taylor’s best guess is that an era of consistently low interest rates has only just begun. He said it would be unrealistic to expect something like lower interest rates from 1982, since interest rates are already so low. If an era of rising interest rates is possible, that also seems unlikely in light of the Federal Reserve’s stated intentions. The chaotic markets of the 1914-1945 period which included two world wars also seem an unlikely guide for the future, as does the 1792-1914 period in which the United States transformed into an industrialized economy.
This is why Taylor believes investors are entering uncharted territory. He predicts that the equity premium in the future will be low – around 3%. If so, stocks in this current era will produce mediocre returns at best.
Remember that long-term bond yields are strongly correlated with their starting yields. For example, the 10-year US Treasury TMUBMUSD10Y,
recently fell 1.61% in nominal terms, and minus 0.79% after inflation (assuming inflation is equal to the current 10-year breakeven inflation rate). A 3% equity premium therefore translates into an expected stock return of only 4.61% annualized before inflation and 2.21% annualized after inflation.
The challenge for investors
Taylor points out that his estimate of the 3% equity bonus “is just a dart-throwing guess.” This is perhaps the most important point of this discussion: a guess is the best one can do. Based on the past four decades, for example, you can project an equity premium of 1.33 percentage point annualized. You can project a higher equity premium if the data analysis dates back to WWII, or a much lower premium if you start the analysis from 1792.
Yet if the financial markets are rather marked by eras that are not alike, then analyzing history more does not necessarily produce a better understanding. McQuarrie makes this point: “Mashing apples and oranges can’t give a better idea of how different fruits taste. “
The bottom line? Humility is a virtue. Those who project confidence because of the amount of history they have included in their models are like those who are often wrong but never doubt.
Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment bulletins that pay a fixed fee to be audited. It can be reached at [email protected]
After: Small-cap stocks won’t go anywhere in the next year, according to best-performing indicator
More: Dow 37,000? This is possible if US stocks organize an “average” summer rally