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Tuesday, September 13, 2011

Solving the equity risk premium puzzle (Business Spectator/Property Observer column)

In the standard literature, the so-called ‘equity risk premium puzzle’ refers to the substantial outperformance of listed shares over safer government bonds. The magnitude of the differential in returns generated by these assets suggested to some that investors were inconceivably cautious, or risk-averse, and thus demanded exceptionally high returns from equities in order to compensate them for the market’s sizeable volatility, or risk of loss.

There are at least three other explanations that I am more sympathetic to. The first is that there is, in fact, only a small—indeed, far too small—equity risk premium over government bonds when you run the right numbers. I will return to that later.

The second (related) argument is that investors’ portfolios have actually been plagued by quite irrational, and poorly compensated ‘risk-seeking’ asset-allocations, which have underestimated the probability of loss in, and relative valuations of, shares compared with far more secure fixed-income assets like cash and government bonds.

I suspect that this irrationality was itself influenced by investor ignorance about corporate capital structure risk and, more fundamentally, the important differences between ‘debt’ and ‘equity’. I have little doubt that these misconceptions continue to prevail at the retail punter level. I would venture they also exist amongst more sophisticated institutions.

One concern is that this equities “obsessive-compulsive disorder” (OCD), as I like to call it, appears to be a peculiarly Australian affair, which is most endemic in our superannuation system. It is an interesting sociological question as to whether this is somehow linked to our unusually pervasive gambling culture.

According to the OECD, Australian super funds have far and away the highest exposures to listed equities of any of the 31 countries they survey (see first chart below). This has manifest in inferior performance vis-à-vis other pension systems around the world.

Here the OECD finds that over the last three years, “the worst [pension] performance was observed in Spain (-2.0% nominal, -3.8% real), Australia (-2.8% nominal, -5.6% real), Portugal (-3.1% nominal, -4.1% real), and Estonia (-3.7% nominal, -7.7% real). The average, yearly net return over the period [for all 31 countries] was 5.4% in nominal terms and -0% in real terms [ie, dramatically higher than Australia’s results].”

As I have explained before, debt ranks ahead of equity, commits to repay you the dollar value of your original investment, and promises a pre-determined rate of return.

Equity does not offer you a guarantee to return your capital, is subordinate to debt in the event of insolvency (ie, you get paid last), and directly exposes you to the risk of loss in concert with the prospect of non-specified gains.

One of the great ironies of the asset-allocation puzzle that has led to excessively high weights to shares in Australian portfolios is, as I explained here, that debt is, by its construction, far easier for punters to understand, analyse and value than equity.

The lay observer would not, however, think this given the vast industry complex that has been built up around promoting the sharemarket—with countless online retail stockbrokers and media backers—that in turn make investing in shares seem like it need no more qualification than a functional index finger.

But as any professional analyst understands, the highly uncertain assumptions and complex discounted earnings models required to estimate the prospective equity returns that may or may not materialise from a listed company are orders of magnitude more sophisticated than valuing a floating-rate debt security.

It is even more bizarre that the regulator, ASIC, makes it harder for mums and dads to invest in debt than equity, given the greater certainty, security and transparency of the former over the latter (the minimum direct investment is $500,000).

Any chump can create an online trading account to gamble, on say, unsecured Bendigo & Adelaide Bank shares, but heaven forbid if you want to invest in Bendigo & Adelaide Bank’s senior or subordinated debt securities.

Chalk that one up as a win to the banking cartel that does not want to be disintermediated from the supply of business credit by an ascendant retail debt capital market, and the hordes of sharemarket salesmen relentlessly spruiking the ‘value’ and purportedly high returns associated with this company or the next. For what it is worth, Aussie government bonds have outperformed global equities over the last 30 plus years. That is to say, there has been a negative equity risk premium between global shares and Aussie government debt.

Another way of thinking about this is by considering the risk in your own home. When you buy a home, you provide the cash deposit, which is your ‘equity’. The bank supplies a home loan, which sits ahead of your deposit in the capital structure. If things go belly-up, the bank’s debt ranks ahead of your equity. They get to sell the home, recover their principal and any unpaid interest, and only then to you get the left-overs, assuming there are any.

Now consider a listed company. Would you prefer to be the bank, or the secured lender to that company, by investing in its debt, or be the mug that furnishes it with the risky equity capital, equivalent to the deposit for your home?

A second explanation of the equity risk premium puzzle is that the difference in total returns delivered by shares and government bonds is not as great as some claim. For example, Challenger Financial’s actuaries have run analysis that shows once you control for measurement mistakes in the academic literature, such as forgetting that government bonds have a ‘total return’ including both capital gains and income, the performance gap between Australian shares and Australian government bonds has only been about 2% per annum (our numbers are similar). On a risk-adjusted basis—ie, controlling for the probability of loss—shares look like a comparatively poor investment. In the technical jargon, the so-called “Sharpe Ratio”, or risk-adjusted return, attributable to shares is about half that yielded by Aussie government bonds.

This actually inverts the entire equity risk premium puzzle on its head: could it be possible that, in Australia at least, the question is why listed shares have not offered more (rather than less) compensation for their very high risks? Now I have never heard or read that question before. An ensuing query, therefore, is whether in Australia the equity risk premium puzzle is about understanding if investors have had too much—as opposed to too little—risk tolerance. This arguably fits more comfortably with the academic research literature on investors’ behavioural biases.

One issue that the Challenger analysis has yet to address is the subject of ‘survivorship bias’, which, if it exists, would further reduce the disconnect between bonds and shares.

There are at least two forms of survivorship bias. The first is the likelihood that prior to 30-40 years ago, Australian sharemarket indices only include ‘winners’—or the companies that have survived—and do not retain data on the performance of ‘losers’—ie, those that have delisted due to corporate distress.

A second more insidious bias, which remains to this day, is that when a company goes into insolvency, trading in its shares is suspended, and the last price recorded by the ASX is the pre-insolvency value. Oftentimes the company’s shares will never trade again. Yet as the so-called ‘residual claimants’, shareholders get paid out last after all other creditors, and their realised returns are, as a result, frequently a fraction of the value implied by the last traded price.

Following the circa 50% losses experienced in the global sharemarket collapses in 1987, 2001, and 2007-08, and the more recent turbulence wrought by the North Atlantic sovereign debt crisis, Australian retail and wholesale investors are beginning to make some belated changes to their asset-allocations that will see them reduce their equities exposures in favour of higher cash and fixed-income weights. While this could take years to fully implement, it may further depress equity valuations until such a point as the expected future returns implicit in prices offer adequate compensation for shares’ exceedingly high risk.

There is also a case that this dynamic will be amplified even more as the population ages and risk-aversion increases: that is, demographic change will drive greater appetite for cash and fixed-income securities.

The funny thing is, the more the North Atlantic financial markets crap themselves, and the more pressure that is brought to bear by investors, economists, commentators, politicians and ‘policymakers’ on the RBA to cut—or, in extremis, hold—interest rates, the more bullish I feel on both housing and shares!

As of this morning, the interest rate futures markets are pricing in 5.7 cuts—of one quarter of a percentage point each—to the RBA’s official 4.75% target cash rate by July next year. That would bring the cash rate down to one hike above its 3% GFC nadir, and slash mortgage rates back to near-40 year lows (see chart).

Now I don’t really pay much attention to the financial markets’ precise predictions, because they are so consistently wrong. They are, however, informative in a directional sense. And what makes them more credible is that many smart and thoughtful economists (and investors) are jumping on the doom-and-gloom bandwagon with some notable exceptions, including yours truly. (I am probably the only person in Australia who thinks the RBA will still nudge rates higher this year.)

AMP, Deutsche Bank, Goldman Sachs and Westpac all believe that the RBA will cut rates by between 1-2 times before we move into 2012. Macquarie Bank forecasts there will be four rate cuts by the end of next year.

Concurrently, there is mounting pressure being placed on the RBA’s staff by its own Board, members of which are reported to have been calling for rate cuts for months, and by untold vested interests—union officials, retailers, exporters, politicians, and sharemarket investors—to, in effect, look past, the RBA’s official 2-3% per annum inflation target in the name of ‘shoring up’ employment and growth. As the accountant, Anthony Bell, argued the other day, why shouldn’t we be allowed to run a Chinese-style inflation rate?

Since November last year, the RBA has acquiesced, ignoring consecutive way-above-target ‘core’ inflation results in the first half of 2011 that would ordinarily have led to reflexive hikes. Yet the RBA has not simply overlooked the official ABS inflation numbers, and the two measures of ‘underlying’ inflation that the RBA itself designed (which remove the effects of the floods and so forth).

The RBA has also disregarded its own official forecasts for underlying inflation over the next three years. In the two editions of its Statement on Monetary Policy published this year, the RBA projected that core inflation would remain materially above the mid-point of its target 2-3% per annum range out to 2013. Indeed, it is predicting that inflation pressures will rise over time while also acknowledging that its historical forecasts have had a worrying tendency (the RBA’s characterisation, not mine) to under-club the ultimate strength of Australia’s inflationary pulse.

In his most recent parliamentary testimony, Governor Stevens argued that, “There are periods of tremendous turbulence when I think it is a very good thing for policy to just sit still…You can only do that if you feel that you are in some sense ahead of the game on inflation, which I have felt [emphasis added].”

Now noting my points above, and that Governor Stevens and his colleagues went on to describe the underlying inflation pressures reported in the first half of 2011 as “troubling”, “broad-based”, “surprising”, and not directly due to the resources boom, it is an arduous task to understand how the Governor can possibly claim that the RBA currently feels “ahead of the game” on inflation.

This verbiage seems to fall into the same camp as his claim several testimonies ago that, “[I]n my experience the Reserve Bank never has leaked and, if I can help it, it never will.” As the commentator, Alan Kohler, wrote in response at the time, “Yeah, right, and Tiger Woods is gay.”

More factually, the historian, Professor Stephen Bell, has highlighted the problem of RBA leaks using the example of former RBA Board Member, Hugh Morgan:

“In mid 1997 the Bank's apparent confidence in an 'ethical fix' was questioned when it was revealed that Western Mining Corporation had quadrupled its forward sales of gold [to hedge the risk of price falls] at the same time as the RBA was secretly selling two-thirds of its gold reserves. Hugh Morgan, the CEO of Western Mining, was a member of the Bank's Board at the time. He did not, and was not required to, absent himself from the Board meetings, which dealt with the gold sales.”

A related irony here is that the RBA and its Governor have for years been criticising investors for spending too much time focusing on the ‘North Atlantic’ economies, and paying insufficient attention to the developing world. This is because a remarkable 65% of all Australian goods exports now go to ‘emerging’ (as opposed to ‘developed’) countries, with 75% sent to Asia alone.

It is also because over 70% of global GDP growth during the last decade has been created by countries outside of North America and Europe. Even if we ignore ‘growth’ and simply examine shares of global output measured in US dollars, we find that over half of the world’s output does not derive from the G7 economies.

In short, the world is a much bigger and more diversified place than the financial markets seem to believe. The risk is that the RBA itself has fallen for the same trap by setting Australian monetary policy on the basis of US and European capital market turbulence. The RBA explicitly acknowledged as much when it intimated in the latest Minutes that the Board would have raised rates in August were it not for the US debt ceiling crisis.

While it is not my own central case, if the financial markets and the more bearish economists are proven prescient, and the RBA has come to the end of this tightening cycle, Australia’s most interest rate sensitive sector—housing—is likely to be a good place to be.

We have had no house price growth across Australia’s combined capital cities for 19 months now. At the same time, household disposable incomes, as measured by the ABS’s quarterly National Accounts, have grown rapidly at a circa 7-8% per annum pace (see chart).

If the bears are right, and mortgage rates come down 140 or so basis points to around 5.6%, we are likely to see the return of quite healthy house price growth as savers are punished—via lower cash returns—while geared investors flock to the perceived security of bricks and mortar.