Equity Premium: Product of Monetary Policy Interventions

In our previous article Why Stocks Could Outperform Bonds Over The Next Decade

However, Mr. Gerald Jackson of Brookesnews has an excellent theoretical dissertation underpinning this so called equity premium debate, (bold highlights mine)

we laid the case why I think stocks could outperform bonds (mostly from the inflation perspective)Let me quote Mr. Jackson,

``However, we live in the real world of uncertainty where markets exist because we do not have perfect foresight. Therefore the role of the market is to coordinate and distribute expectations and masses of incomplete knowledge to market participants who will then act according to their own expectations and experience. The world of uncertainty brings us to the nature of profit and its effect on shares. In a progressing economy — one that enjoys rising per capita investment — aggregate profits will always exceed aggregate losses."

``Obviously, if firms consistently make profits then the value of their shares must steadily rise. This means that equity returns must exceed the return on bonds. The reason is the nature of profit. Ludwig von Mises explained that profits are maladjustments between supply and demand. Hence factors become underpriced in relation to the value of their products whenever a genuine profit appears."

``Let us assume a general equilibrium position where all returns have been equalised. There would be no profits or losses and uncertainty would have disappeared. Let us now introduce uncertainty and losses but not profit into our model. Obviously a risk premium would now emerge. It should be equally obvious that the difference between the return on bonds and equities would be pure risk.

``The final step takes us into the real world of profits and losses where economic progress is the order of things. We would now find that the difference between bonds and equities has widened further because we now have to account for aggregate profits exceeding aggregate losses. Therefore profit equals any return over the rate of interest plus any attendant risk. In a progressing economy new ideas, inventions, techniques, innovations, etc, are being constantly applied through new capital combinations. This process constantly renders older capital combinations obsolete and leads to their dissolution thereby creating profitable opportunities."

In short, the fundamental difference between stocks and bond is profit. And by nature stocks, due to its claim on capital goods or earning streams, should outperform bonds.

But the so-called equity premium is the attendant volatility emanating from government policies from which Mr. Jackson defines as the ``gross monetary mismanagements distorts markets and inflates share prices. Sooner or later unavoidably painful corrections have to be made. When this happens the market gets the blame and calls are made on politicians to take action. This invariably results in highly damaging interventionist policies. All because basic truths about how shares are truly valued and how bad monetary policies cause financial crises have been forgotten."

Why Stocks Could Outperform Bonds Over The Next Decade

``The investment world has gone from underpricing risk to overpricing it. Cash is earning close to nothing and will surely find its purchasing power eroded over time. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."-Warren Buffett, annual letter to Berkshire shareholders

Despite the surfeit of available information via cyberspace, much of these do not necessarily account for as knowledge, since pieces of information could be irrelevant or just plain rubbish or built around flawed presumptions.

In last week’s Should We Follow Wall Street?, we disputed the idea of a universally accepted technical wisdom from Wall Street.

We made as one of our example the polemics about the equity premium or the comparison of the returns of bonds versus stocks.

Nitpicking over hundreds of years of data, for us, would seem like another exercise of vanity.

Unless humanity will reach a state of human-machine convergence or Singularity soon, from which futurist Ray Kurzweil predicts that ``our intelligence will become increasingly nonbiological and trillions of times more powerful than it is today—the dawning of a new civilization that will enable us to transcend our biological limitations and amplify our creativity,” looking at an investment horizon of 100 years or more is downright impossible or impractical to put in practice.

Moreover, given the rapidly evolving dynamics, largely supported by technological innovation, such devotion to interpret a mountain of market historical data defeats Wall’s Street’s basic mantra of “past performances doesn’t guarantee future outcomes.”

So even if bonds have been proven to outperform stocks in the longest run, it doesn’t necessarily translate to the same outcome over the next coming decades.

Lastly, it’s about data mining too. Advocates of one particular cause tend to use time reference points that support their underlying bias, as different time periods yield different results.

However, over the next decade or so we believe that stocks should outperform bonds.

Here are the reasons why.

One, global government in an attempt to reflate the markets has imposed policies, such as massive stimulus spending, a cheap money environment as shown by the steepening of the yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle] and quantitative easing, that has indirectly been supportive of the equity assets.

Second, under the onus of over indebtedness, afflicted governments have been tacitly inflating away these burdens through inflationary policies. And since inflation erodes a currency’s purchasing power, higher inflation thereby reduces real gains on fixed income.

Third, as governments take on more debt to substitute for declining private sector demand, inflationary policies serve as an indirect way to default on debts.

Fourth, global supply of debt will transcend available capital.

Fifth, the mercantilist inclinations of global governments will employ measures to prevent the necessary adjustments in the values of their respective domestic currency so as to protect “export markets”.

Hence, inflation will likely be a global phenomenon than one limited to debt scourged nations.

Sixth, even in the US, financial asset pricing has increasingly been influenced by inflation more than capital gains.

In fact, it is nearly catching up with dividends. [see our earlier discussion on Worth Doing: Inflation Analytics Over Traditional Fundamentalism!]

Figure 6: Economagic.com: 10 Year Treasury In A Bond Bull Market For 27 years!

Seventh, bonds have been in a bullmarket since the early 80s [see Figure 6], hence ``it would be almost impossible for bonds to generate the same amount of capital gains as they did in the past” argues Peng Chen, Ph.D., CFA, and Roger Ibbotson, Ph.D. (HT: Gully)

This suggests too that the US treasury bearmarket could likely be as long as the last bullmarket (27 years) or the previous bearmarket (30 years).

Figure 7: Manual of Ideas’ Instablog: Tobin’s Q

Lastly, in an inflationary environment the cost of replacing company’s assets would increase, hence stock prices should also adjust to reflect on this changes, based on the Tobin’s Q ratio, or a measure defined by wikipedia.org, ``comparing the market value of a company's stock with the value of a company's equity book value. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of the book equity.”

If the derived value is greater than one then this suggest of overvaluation [as market prices are greater than the company’s assets] and if the value is less than one then it is an indicator of undervaluation.

Notice that during the stagflationary decade of the 70s to the early 80s the Tobin’s Q had largely been undervalued or that stocks were priced below their replacement costs, although stocks and bonds had marginal differences in returns, according to Shawn Allen of Investor’s Friend ``The 20 years from 1966 through 1985 were ugly all around. Stocks came out slightly ahead but were the best of a dismal lot.”

As a caveat, since inflation impacts asset prices relatively, stocks won’t likely perform in a uniform manner and would likely be distinguished based on the industry.

So yes, like Warren Buffett, we think stocks will outperform bonds over this cycle.