Foresight - Fall 2023

As we continue to wait for one of the most predicted recessions in recent memory, we think it important to put perspective on the frequency of economic recessions versus the fear of recessions. A recession is defined as a period of two or more successive Quarters during which a country’s GDP declines. Looking back over the 30 years since 1994, there have been three recessions in the United States and two in Canada. In total over the last 30 years (360 months), the US economy has been “in recession” for a total of 28 months and 10 months for Canada. The US was hit more severely in the financial crisis of 2008/09 and was in recession then for 18 of those 28 months. Meanwhile, since 1994, the S&P 500 Index has had four Bear Markets while the Canadian TSX 60 Index has had six. During these thirty years, the GDP grew in the US by 3.5 times and in Canada by 3.7 times.

During these thirty years on the borrowing side, the prime lending rate in Canada started at 5.5%, rose to a high of 9.25% in February 1995, then to a low of 2.25% in 2010, to 2.45% recently in 2020/21 to today’s rate of 7.2%.  During this period on the lending side, Canada 10-year bond yields were 7.75% in 1994, increased to 9.34% in 1995 and remained in the 4-5% range right through to the financial crisis in 2008, hit their low of .95 of 1% in 2020 and are 3.7% today. Lenders are finally starting to see some more reasonable returns for the risk of lending their funds.

An investor’s total return is the sum of two components: cash income plus price appreciation. The long term growth of an economy, with resulting increase in company earnings and dividends, contributes far more to long term real returns than price appreciation. Focusing on the S&P 500 as a proxy for the world’s largest economy, in 1994 the 500 companies in this Index earned $31.75 per unit. In 2022 they earned $219.49 per unit. During these years, the total dividends paid out by the S&P 500 were $958.76, which is just over two times what an investor paid for the Index back in 1994.

In addition during these thirty years, the S&P 500 Index grew from 473 to its current level of 4,365, a 9.2 times increase, or 7.7% nominal pa., while the TSX 60 Index grew from 227 to 1214, a 5.3 times increase, or 5.7% nominal pa.

Economies and their governments, companies, and family households have prospered even during periods when interest rates were much higher than the lows experienced, for instance, in 2008/9 and in the 2020 Covid pandemic.

Recessions are part of the economic cycle, and the next recession will come, whether in 2023, 2024 or beyond! Meantime, businesses continue to adapt to their economic environments—whether that be higher interest rates, climate change initiatives, ensuring security of supply chains or the changing demographics of the work force. Some businesses will suffer while others will grow and yet others will be created. 

L     O     N     G      P     E     R     S     P     E     C     T     I     V     E

You may remember, post-Y2K, the publication of a UK book called “Triumph of Optimists” by Dimson, Marsh and Staunton (“DMS”). It was a 300-page book reporting on the entire 20th century of investing. We covered it extensively at the time and over these intervening years. We recently purchased its 23 year update to present time. The collection of tables, charts and wisdom is very insightful. The one stat they failed to report was inflation in book prices. We paid $150 in 2001 and $700 in 2023...an “intelligence inflation rate” of 7.25% pa. We highlight with the following:

Asset allocation

Asset allocation between bonds and equities is more about dampening volatility than maximizing  returns. DMS use the terms “drawdown” and “recovery”. The former is the drop in value of a portfolio at a particular time versus its most recent high. The recovery period is the duration from that drop back to/above the previous high. This recovery can be measured in both nominal and real terms. DMS strongly focus on real returns, ie inflation-adjusted returns, across all asset classes. DMS data show that even bottom-decile US investors can realize a positive equity real return by holding over 20 years. Real US bond returns in the bottom decile, on the other hand, would take 50 years. Our article A Tale of Two Returns speaks to this same point, but in shorter timelines.

The US stock/bond correlation has been only .2 over 123 years. That correlation has been negative over the last two decades, which is unlikely to continue. As a result, a balanced portfolio has a lower drawdown and a faster recovery. Over 123 years, the variance statistic of real returns of a balanced portfolio was 13.5%, versus 19.9% for all-stock, and 10.7% for all-bond, portfolios.

Bonds

Today’s adult investors have grown up in a bond bubble. The early ‘80s began a 40 year golden era for bond investors, in which returns were equity-like and with less volatility. For that period, the world bond index returned 6.3% pa (real), slightly less than world equities at 7.4%. That bond honeymoon crashed recently—the real return on world bonds for 2022 was –27%.

Lenders are caught between two rocks—teasing out a decent premium for debtor risk and bearing inflation risk over the duration of the debt maturity. The theory goes: the riskier the debtor, the higher the risk premium from a so-called risk-free loan. DMS observe that the historical premium for debtor risk has been modest. The duration of the loan also contributes to a risk premium. Investors don’t tend to calculate their real bond return. Even risk-less bonds can require a holding period greater than half a century to achieve real bond returns!

Stocks

The top 7 countries by 123 year geometric real annualized returns (ranging from 7% to 5.7%, in descending order) were South Africa, Australia, USA, New Zealand, Sweden, Denmark and Canada. The repeated list with arithmetic real returns (ranging from 9.2% to 8.0% in descending order) were Finland, South Africa, Japan, Portugal, USA, Australia and Sweden. Over this period, high returns tended towards resource-rich and New World countries. Those real returns for an all-world portfolio were 5.0% and 6.5%.

Investors view long run price appreciation as the prime driver of stock returns. Alternately, DMS cite four causes. The most significant is reinvesting dividend income - the crucial contributor to long term wealth accumulation. Second is the growth in company dividends. Ironically, DMS data show that real dividend growth is quite small - only five countries had real dividend growth greater than 1% over 123 years! Third, the price/earnings ratio indicates the price an investor is prepared to pay in order to receive the company’s dividend payout. That multiplier, representing investor enthusiasm, has grown only minorly in all but four countries over 123 years. Lastly, global investors’ returns will be impacted by the change in real exchange rates with their own domestic currency. As written below, the long term impact of this component has been found to be very small.

Diversification

Our approach to global investing is supported. DMS suggest all investors should do so. One of its main contributors is significantly lower standard deviation of returns as compared to a pure domestic portfolio. They quote a reduction from an average single country of 29% to 17-18% for an equally-weighted 21 country portfolio. Globalized trade has increased the extent to which countries move together, but there is still significant risk reduction.

Portfolios with 10-20 holdings do not achieve sufficient diversification. In the second quarter of 2023, our monthly Innovation Program added stats to each portfolio to track the number of equity holdings and average $ size thereof. Further, we aggregated this data across all portfolios by portfolio-equity size range to monitor consistency and outliers.

Inflation

123 year geometric inflation rates range from 2.1% to 12.2%; arithmetic rates range from 2.2% to 35.4%. Wars tend to have a lot to do with the country difference in those two statistics. Canada, Switzerland the US and Netherlands are the lowest, in both measures.

Inflation usually entices rising interest rates. Bond yields suffer in inflation but can provide relief during deflation. Street–smarts hold that equities perform well during inflation. DMS disagree. Economists talk of the incidence of inflation—who bears it? The story is that, while input costs of labour and materials go up, businesses are able to pass these along to their consumers, and perhaps even increase their profit! However, in a century-plus, which featured roughly equal frequency of rate-rising and rate-falling periods, US stocks fell in 9.4% of falling environments and rose in only 2.6% of rate-rising. DMS opine that a rising equity market during inflation is “camouflaged” in what is really a play on shifting risk & reward for buying equities.    

Foreign exchange

When a domestic investor crosses the border and invests out in the world, the return is what that stock makes abroad plus/minus the change in currency exchange over the period. This extra risk dissuades some investors from ranging abroad, particularly if they depend upon the portfolio income for cash flow to spend. DMS observe that change in the exchange rate is very correlated with the difference in the two countries’ inflation rates. Real exchange rates (ie adjusted for each country’s inflation) are relatively stable over the long term. They go on to observe that currency hedging is ineffective for both equities and bonds, even in relatively brief multi-year periods. Instead, global investors should focus on purchasing power parity, which equalizes inflation-adjusted currency prices.   

Volatility and sleepless nights

In the 37 years from the 1987 Crash to the Ukraine war, there have been 16 major spikes in market volatility in response to Nick Murray’s “Apocalypse du Jours”. During this period, the average time for Apocalypse volatility to revert to the volatility norm was 95 trading days. On average, it took only 6 trading days to evaporate half of the spike. Studying 123 years and 2,487 data points, DMS observe that future market real rates of return, in bonds and equities, are highly correlated with current, real interest rates, and equities consistently outperform bonds by a healthy margin.

The 123 year DMS data give further perspective to market traumas. Almost all of the Apocalypses over that entire period are barely perceptible, with the Great Depression being the most notable. That said, investor success hinges upon timelines, temperament and purpose ..”What’s the money for?” speaks to timelines and purpose. DMS speaks to temperament…. 

In closing, DMS wisdoms are that “a long term strategy is useless if the investor cannot stick to their plan” and “Our research supports the approach of sticking to a diversified portfolio of uncorrelated factors that you believe in for the long term, instead of seeking to tactically time them”.

A TALE OF TWO RETURNS

“It was the best of times, it was the worst of times…”

Such was the famous opening line of Charles Dickens’ A Tale of Two Cities in 1859. He carried on with more powerful prose:

“It was the age of wisdom, it was the age of foolishness,

it was the epoch of belief, it  was the epoch of incredulity,

 it was the season of light, it was the season of darkness,

it was the spring of hope, it was the winter of despair.”

His book was set at the time of the French Revolution and in the cities of London and Paris. But he could be a stock market analyst in today’s world, speaking about people’s investing behaviours. 

Note that he didn’t become famous for saying “It was the average of times”. And so, we must draw upon, but diverge from, his famous insight as we tackle a related topic in modern-day investing….rates of return.

We humans have been counting, and ac-counting, since we climbed out of the primordial mud. Our numeracy has its comfort-zone. BIG numbers overwhelm us and small numbers fail to impress. Perhaps we are the Three Bears of Numbers! We visited this in the Summer issue of Foresight: considering the distance of 251,681,994 kilometers to Mars versus a 7.26% compound rate of return on a portfolio.

Since that issue, we have had another real world encounter, this time with an investor friend of mine who recounted gleefully that her investment manager had got her a 26% rate of return last year. At least three different factors can cause such a great return; first, the market indeed had a great year in a period of economic flourish; second, that great number was in fact a market recovery from a previous beating; and third, the simple arithmetic trick of mark-ups and mark-downs. This last point is old hat for wholesalers and retailers, and tricks us to a numerical world where 25 = 20! A 20% markDOWN on a good selling for $100, requires a mark-UP of 25%, just to get it back to $100.

And so it is with the market. In the financial world, a market recovery of 25% after a “crash” of 20% in the previous year, is a two-year result of zero %. For transparency, that 25% ought to be classified as a “recovery” rate of return—getting back what you just lost - to give the investor proper perspective. In the real world, such two-year results won’t tidily square to zero...the second year may not fully recover, or it might fully recover PLUS make some more (this latter, we call “productive” return). To be equitable, we should also apply this logic in the opposite direction...when we have a great year, followed by a losing year…..call that a “correction” return.      

The financial services industry has commenced to report “compound” returns….but on 3 and 5 year rolling periods...not the 2 year period above. Einstein famously weighed in to declare “compound interest is the eighth wonder of the world” and “the most powerful force in the universe”. Compound returns come in two flavours: cumulative and average. The latter is the reported industry norm. A 2 year compound return, either average or cumulative, would provide the same perspective as “recovery” and “productive” returns.   

Fortunately, the annual market returns (particularly for balanced portfolios) do not gyrate so significantly that we need to build “recovery” returns and “productive” returns into ongoing financial accountability. But when those “black swan” times come, it is insightful to dust off this valuable perspective.  

At Trivest, we have been reporting average compound returns for decades. Recently, we have added cumulative compound returns for clients to appreciate the Einstein effect! And we will keep an eye on reporting “recovery” returns for greater transparency in black swan times.