Memo to: Oaktree Clients
From: Howard Marks
Re: The Outlook for Equities
March 19, 2013
It doesn't take much to get me started on a memo. In this case one sentence was enough, in an article from the February 4 online edition of Pensions & Investments, as described by FierceFinance on February 28: "The long-term equity risk premium is typically between 4.5% and 5%."
There's little I hate more than investment generalizations. For years, for example, self-styled authorities on the high yield bond market would say "bond defaults typically take place 2-3 years after issuance." That always set my teeth on edge. The time to default might average 2-3 years, but unless (1) that's also the most common time period (the mode) and (2) not a highly variable parameter (which I think it is), that generalization is absolutely useless.
In fact, I like the way Mark Twain summed up on the subject more than 100 years ago: "all generalizations are false, including this one." I consider most investment generalizations as useless as that great oxymoron: "common sense."
Back to equity risk premiums. The FierceFinance article in question led with the sentence, "The 'great rotation' back into equities from bonds is unlikely to be seen in 2013 among most defined benefit pension funds in major markets, including the U.S., U.K. and Netherlands." It included a number of what I consider provocative statements:
• that pension funds do want fewer bonds but generally not more stocks (raising the question of where the money will go, and specifically how much money can responsibly be absorbed in asset classes other than stocks and bonds),
• that, according to one consultant "There is recognition that bonds represent minimal-risk assets, so it's difficult for (plan executives) to abandon bonds in favor of equities. . ." (This overlooks the fact that there's no such thing as a minimal-risk asset regardless of price, and few assets that have been the beneficiaries of years of strong cash inflows can really be "minimal-risk"), and
• "that investors are taking short-term tactical advantage of the rising equity premium by, for example, allowing multiasset managers to drift toward the higher end of the equity allocation range."
So there we are, in the third bullet point, back to the matter of the equity risk premium.
Everything You Ever Wanted to Know About Equity Risk Premiums (and Much More)
The equity risk premium is generally defined as, "the excess return that an individual stock or the overall stock market provides over a risk-free rate." (Investopedia) Thus it is the incremental return that investors in equities receive relative to the risk-free rate as compensation for bearing the risk involved.
Read or download the whole letter in the slidedeck below:
