Keep in mind that near-term returns much higher than 5% annually would essentially be shifted from future years, meaning that higher returns today simply imply even lower long-term return prospects tomorrow. For very long-term investors, say 15 years or more, such variations hardly matter. By our estimates, investors are looking at prospective 15-year total returns in the range 5.8-6.5% annually, with enormous volatility in the interim, no matter how you cut it.
I should note that while I clearly underestimated the extent to which investors would concentrate their 10-year return prospects into an 8-month span from March to November of 2009, this was no fault of the valuation methods. Rather, I refused to discard lessons from prior historical credit crises in the U.S. and internationally. Except for the relatively contained S&L crisis, no major credit crises were observed in post-1940 U.S. data (which is what we use most heavily in our investment analysis). It is unfortunate that we would have actually performed better if I had assumed that the recent downturn was nothing but a typical post-1940 recession and recovery, but I am still convinced that this would not have been appropriate. When you develop a model using some set of data that includes valuations, market action, economic conditions, and other variables, you can't reasonably apply it to data that is clearly "out of sample" and unrepresentative of what you observed in the data underlying the model. Rather, it's essential to examine additional data that is as representative as possible of conditions you actually observe. In the case of 2009, we could not rule out other post-credit crisis evidence (such as pre-1940 data), and (unfortunately, as it turned out) that data implied the need for much more stringent valuation criteria than post-war data did.
I remain unconvinced even now that we should view the current economic climate as a standard post-war economic cycle. Still, the experience of the past few years has clearly added to our post-war dataset in that it now contains a full-blown credit-crisis. Every new data point adds information, either in creating new distinctions, or increasing confidence in the distinctions one has already learned. The past three years have confirmed much of what we already knew about valuation, while the enormous volatility of prices, despite an overall market loss, has contributed significantly to our analysis of market action.
In any event, whether or not one believes the current economic cycle should be viewed as a "typical post-war recovery," it is clear that our valuation methods have been accurate measures of likely market returns over time - even during the recent crisis. At present, the long-term outlook for equities is unfavorable on the basis of valuation, so regardless of shorter-tem influences, I expect that long-term investors are likely to be ill-served by investing in stocks at current levels.
Fed Policy and QE
Over the short run, two policies have been primarily responsible for successfully kicking the can down the road following the recent financial crisis. The first was the suppression of fair and accurate financial disclosure - specifically FASB suspension of mark-to-market rules - which has allowed financial companies to present balance sheets that are detached from any need to reflect the actual liquidating value of their assets. The second was the de facto grant of the government's full faith and credit to Fannie Mae and Freddie Mac securities. Now, since standing behind insolvent debt in order to make it whole is strictly an act of fiscal policy, one would think that under the Constitution, it would have been subject to Congressional debate and democratic process. But the Bernanke Fed evidently views democracy as a clumsy extravagance, and so, the Fed accumulated $1.5 trillion in the debt obligations of these insolvent agencies, which effectively forces the public to make those obligations whole, without any actual need for public input on the matter.
Notably, what kicked the can was not quantitative easing per se, but rather the effective guarantee of Fannie and Freddie's debts. In and of itself, QE did nothing but to provoke a decline in monetary velocity proportional to the expansion in the monetary base, with little effect on either real GDP or inflation. When QE was pursued in Japan, it did nothing but to provoke a decline in monetary velocity proportional to the expansion in the monetary base, with little effect on either real GDP or inflation. In our view, an additional round of quantitative easing will do nothing but to provoke a decline in monetary velocity proportional to the expansion in the monetary base, with little effect on either real GDP or inflation.
