RISK AND RESILIENCE
Patterns in Equity Returns
september 2013
BlackRock
Investment
Institute
Edward Fishwick
Co-Head of
BlackRock’s Risk
and Quantitative
Analysis Group
What Is Inside
First Words and Summary.......................................................................3
VOLATILE Traits.................................................................................................... 4–6
Russ Koesterich
BlackRock’s Global
Chief Investment
Strategist
return drivers............................................................................................... 7–10
Inflation and Interest Rates .........................................................................................7
Economic Growth...........................................................................................................8
Dividends and Earnings.................................................................................................9
Currencies and Capital Structure..............................................................................10
COMPLICATION: CORRELATIONS.....................................................11–12
Ewen Cameron Watt
Chief Investment
Strategist, BlackRock
Investment Institute
Correlations and Returns ........................................................................................... 11
Portfolio Allocation......................................................................................................12
The Curious Case of LOW BETA............................................... 13–15
Volatility and Bondification ................................................................................ 13–14
Low-Volatility Paradox.................................................................................................15
}
Equities have generated strong returns over the
long run (in most countries).
}
Losses of 30% or more occur once a decade on
average in US equities.
}
Patient equity investors are usually rewarded.
}
Most equity markets have lagged US returns.
}
Equities are much more resilient to inflation
than bonds—but not bulletproof.
}
Equities are volatile compared with company
fundamentals and the business cycle.
}
Company fundamentals are prime drivers of
returns in the medium term.
}
Prices can take a long time to catch up with
corporate performance.
PR O S
C ONS
VS
Equities
Sub tle ties
}
Index averages mask huge disparities
between countries, sectors and
companies.
}
High correlations do not always
mean similar returns—or low
dispersion of returns.
}
Currencies have a big impact on equity
returns—especially in the short run.
}
Low volatility has outperformed—
but is vulnerable to rising rates.
The opinions expressed are as of September 2013 and may change as subsequent conditions vary.
[2]
R I SK AN D R ES I L I ENCE
First Words
and Summary
Stocks have always been volatile. Losses of 30% or
more have occurred roughly once a decade in US equity
markets—and more in some other countries.
The new millennium has not been kind to equity investors.
Two market crashes soured many on the equity markets.
Some cut their allocations to equities, and others deserted
the stock market altogether.
A global rally from the depths of early 2009 has made up
for the losses on paper—but it has not felt like a bull market
to many investors. Bonds became the kings of the new
millennium. They generated higher returns than equities—
with a lot less volatility.
3 EQUITy
INSIGHTS
History suggests it is premature to throw in the towel.
1
EQUITIES
ARE RISKY
Equities are volatile—and
have been throughout history.
Get used to it.
2
Yet patient investors are usually rewarded for staying the
course—provided they are able and willing to stick around
long enough for prices to catch up with improving corporate
earnings and balance sheets. Warning: It can be a long wait.
What are the rules of this waiting game? We highlight the
inherent risks of stocks, detail drivers of equity returns and
flag complexities such as correlations and the paradoxical
outperformance of low-volatility strategies.
We do not discuss whether it is a good time to buy
equities—read our investment outlooks for those insights.
Nor do we propose a grand theory on equity markets.
Instead, we provide pieces of a dynamic puzzle that
investors will want to solve themselves:
PATIENCE
PAYS OFF
Investors willing to hold
equities for 10 years or more
have a high chance of earning
a positive real return.
}Inflation: Equities tend to do well when inflation is in
the sweet spot of 2%–3% or lower. If inflation accelerates
(especially over 4%), real returns dive—but ­equities still
outperform bonds. Bonds rule in (severe) deflation.
} Real interest rates: High real interest rates usually
herald high equity returns and vice versa. One
explanation: The higher the real rate, the higher the
premium equities must offer to entice investors.
}Reinvested dividends: They account for the majority of
equity returns in the (very) long run. Yet corporate earnings
trends and financial conditions drive returns in shorter
timeframes, overshadowing dividends.
}Currencies: Foreign exchange swings can make all the
difference in the short term—especially in emerging
markets. Currency volatility tends to affect real returns
less over longer time periods.
}Success bias: Most equity analyses are skewed toward
US data. Long-term investors did not fare nearly as well
in most other countries.
}Growth (1): The level of economic growth matters little
for equity returns in the long run.
3
DIG BENEATH
THE SURFACE
Inflation, interest rates, growth,
currencies, correlations and
volatility can affect returns in
surprising ways.
}Growth (2): Growth direction and inflation levels
can affect short-term returns in eye-opening ways.
}Inside the index: Equity market averages mask huge
disparities in performance across different countries,
industries (who could forget the global tech bubble of
the late 1990s?) and sizes and types of companies.
}Capital structure: Equity holders are last in line when
it comes to corporate payouts. This means changes in
the capital structure (and the cost and duration of
companies’ debt) can affect equity returns.
}Correlations: Asset prices tend to move in lockstep
during crises. This does not mean diversification is
dead: Assets with high correlations can deliver very
different returns over time. And high correlations do not
necessarily mean returns are bunched closely together.
}Free lunch?: Adding a dose of equities to a bond portfolio
can enhance real returns without increasing risk much.
}Low-beta paradox: Low-volatility stocks have benefited
from the bull run in bonds and (more recently) the
“bondification” of the equity market. They may struggle
when interest rates rise.
Pat t e r n s i n E q u i t y R e t u r n s
[3]
Volatile Traits
DRAWDOWNS ALL THE TIME
S&P 500 Drawdowns From Five-Year Highs, 1871–2013
Bear markets and big losses have been around for as long
as bourses. Drawdowns of 30% or more are common in
the US equity market, occurring around once a decade on
average since the 1870s. See the chart on the right. In
extreme cases, the losses can be catastrophic. Investors
who bought at the market’s peak in 1929 had lost more
than 80% of their (nominal) wealth by 1932. Stock markets
elsewhere show even greater volatility.
Despite harrowing drawdowns, the past century has been
(mostly) kind to US equity investors. US stocks have
delivered annualized total returns (nominal) of 9.4%
since 1900, according to London Business School (LBS)
research. In slightly more than two-thirds of years, returns
were positive. Annual excess returns (returns above the
“risk-free” rate on US Treasury bills) of 10%–20% have
been the most frequent pattern. See the chart below.
These averages, however, mask huge variations within any
year and from one year to the next. Returns ranged from a
44% loss in 1931 to a 57% gain in 1933. And these extremes
were tame compared with the experience of some equity
investors elsewhere. Japanese and German stocks, for
example, were pummeled during World War II and its
aftermath, with losses of 96% and 88%, respectively,
between 1939 and 1948 (after accounting for inflation).
The good, the bad and the ugly
Excess Returns of US Equities, 1900–2012
1931
2008
1974
1937
1930
1907
2002
1973
1920
1917
2001
2000
1990
1981
1969
1966
1962
1957
1947
1929
1914
1913
1910
1903
2011
2007
2005
1993
1992
1986
1982
1978
1968
1959
1956
1948
1947
1939
1934
1926
1921
1916
1912
1911
1902
1994
1987
1984
1977
1970
1960
1953
1946
1940
1932
1923
1906
-50 -40 -30 -20 -10
0
2012
2010
2006
2004
1999
1998
1996
1989
1988
1983
1979
1972
1971
1965
1964
1963
1952
1951
1949
1942
1919
1918
1909
1905
1901
1900
10
Dot.com
Bust
1970s
stagflation
-60
WWI aftermath
Financial
crisis
Great Depression
-90
1871 1891 1911 1931 1951 1971 1991
2013
Sources: BlackRock Investment Institute and Robert Shiller, July 31, 2013.
Notes: Chart shows drawdowns in nominal terms from the high in the previous five
years. With contributions by Steve Satchell of Trinity College Cambridge.
MANIAS AND PANICS
What causes the bumpy ride? Equities are much more
volatile than bonds because their future cash flows are
much more uncertain (most bonds pay fixed coupons).
Shareholders are last in line to be paid when a company
goes bankrupt—but capture most of the gains when
businesses (and their cash flows) are growing. Individual
stock prices are ultimately determined by fundamentals
such as cash flows, earnings and sales (see page 9).
}Small changes in expectations of future earnings growth
(especially for high-flying growth equities) can translate
into big moves in share prices.
2009
1997
1995
1991
1985
1980
1976
1967
1961
1955
1950
1944
1943
1938
1927
1925
1924
1922
1904
20
}Discount rates matter, especially for interest-ratesensitive sectors such as utilities (see page 15).
2003
1975
1945
1936
1928
1915
1908
30
}Stock markets have been prone to manias and panics
for centuries (Isaac Newton lost a fortune during the
South Sea Bubble of the 18th century). Prices deviate
from fundamentals as investor sentiment swings
between fear and greed.
1958
1954
1935
40
1933
50 60%
RETURN
R I SK AN D R ES I L I ENCE
-30
In the short term, however, prices can swing wildly. Reasons:
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Sourcebook 2013.
Note: Returns are net of US Treasury bill rates.
[4]
SiZE OF DRAWDOWN
0%
The last point is key. Equities are up to 13 times more
volatile than is justified by changes in fundamentals
alone, research by Robert Shiller shows. Shiller’s work
triggered a flood of papers arguing against or for the
findings. What is clear: Equities are inherently volatile.
steady wins the race
Click for
interactive data
Forward Real Returns of US Equities, 1890–2013
1890s
1900s
1910s
1920s
1930s
1940–1951
6 Months
1 Year
3 Years
5 Years
10 Years
20 Years
1952–1959
1960s
1970s
1980s
1990s
2000s
2010–13
6 Months
1 Year
3 Years
5 Years
10 Years
20 Years
-72%
-25%
-15%
-10%
-5%
t REAL LOSSES
0%
15%
30%
70%
170%
1,072%
REAL GAINS u
Source: BlackRock Investment Institute, June 30, 2013.
Notes: The analysis uses Robert Shiller data. All returns are forward returns over the holding period indicated. Returns are from the start of the year and the midpoint. Teal indicates a
positive real return while orange indicates real losses. Magnitudes of positive and negative returns are indicated by color shading, as in the legend above. The index used is S&P 500
Total Return, adjusted for US inflation as represented by the Consumer Price Index. With contributions by Steve Satchell of Trinity College Cambridge.
staying the course
Bear markets do not last forever. US equities have
delivered positive real returns (returns after adjusting for
inflation) in almost any 20-year period since 1890—a
century that included two World Wars, the Great
Depression and the 1970s stagflation period. See the
chart above. There was one exception: The hapless
investor who bought US equities in mid-1901 was down
4% in real terms two decades later.
Investing in equities is an imprecise science over periods of a
year or less. Fundamentals are often swamped by swings in
market sentiment. Investors in US stocks have made money
two-thirds of the time in any given year, with an average
annual return of 19% since 1890. But they lost an average of
14% a year the remainder of the time.
The risk of losses declines as investors extend their holding
periods. Investors suffered losses in 23% of five-year
periods and 14% of 10-year periods. A small probability,
perhaps, but potentially an expensive one.
Consider a retiree who invested in US equities in mid-1972.
A decade later, the real value of the portfolio would have
declined by 32% after inflation, which peaked at double-digit
rates during that decade. If the retiree had the financial means
and physical health to wait an additional decade, the loss
would have turned into a real gain of 155%.
Timing is (almost) everything in investing. Those who buy
equities near peaks in the market’s valuation (or ahead of
big spikes in inflation and other calamities) have to wait a long
time before seeing the value of their investments recover—
especially after accounting for the impact of inflation.
Pat t e r n s i n E q u i t y R e t u r n s
[5]
the lucky (us) century
The past century has been relatively kind to US investors.
The United States has been the world’s largest political,
military and economic force for most of the period. A stable
political and legal system was fertile ground for strong
equity returns. This introduces a “success bias” into the
(many) studies of equity returns that rely on US data only.
Equity investors in most other countries have not been so
lucky. In France, Italy, Belgium and Austria, there have been
periods of 60 years or more when equity returns failed to
keep pace with inflation. See the chart on the right.
The longest period of losses averaged 40 years across 20
countries, based on reliable stock market data going back to
1900. Most investors cannot wait that long (especially
retirees). Both shareholders and bondholders were wiped
out in the Russian and Chinese revolutions.
This illustrates a key point. Equities are usually a sound
investment over the long run—but only in countries with
stable political and legal frameworks. All bets are off in cases
of war, revolution or government expropriation of assets.
Diversification can help smooth the ride. The volatility of a
basket of global equities tends to be lower than that of any
individual market. Why? The global basket is exposed to a
much more diversified set of economic risks than any one
country. In addition, stock concentration in local markets is
much higher. The 10 largest stocks comprise 60% or more of
total market capitalization in Australia, Germany and
Switzerland, and more than 80% in Russia—versus only
about 10% of total value in the global equity market, our
research shows.
WHAT BUBBLE?
US Equity Performance, 1999–2001
tOtAl CuMulAtivE REtuRN
120%
Russell 1000 tech
80
Russell 1000
0
Russell 1000 ex-tech
-40
2000
2001
Sources: BlackRock Investment Institute and Bloomberg.
[6]
R I SK AN D R ES I L I ENCE
Longest Periods of Negative Real Returns, 1900–2012
Denmark
Canada
Australia
US
S. Africa
N. Zealand
UK
Switzerland
Ireland
Netherlands
Sweden
Finland
Norway
Japan
Germany
Spain
France
Italy
Belgium
Austria
Average Longest
Period Of Losses
0
20
60
40
80
100
YEARS
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Sourcebook 2013.
PEEK UNDER THE HOOD
Another caveat: Studies of equity returns are based on broad
market indices and, therefore, mask huge variations in sector
performance. This is especially true in shorter time periods,
when bubbles or panics can drive valuations in certain
sectors far from broader market averages.
The technology segment of the Russell 1000 Index soared
by 117% in 16 months during the late 1990s dot.com bubble.
See the chart on the left. Yet the broad index rose just 27%
over the same period. The subsequent technology crash was
similarly dramatic. Investors who had been willing to pay top
dollar for tech stocks marked them down to almost zero.
(This type of re-rating is an important driver of equity returns,
as we discuss in the next chapter.) In the five years after the
tech bubble, the contraction of earnings multiples explained
54% of global stock performance. Valuation says little about
the short term—but everything about the long term.
Cisco Systems is illustrative. The stock peaked at almost $80
per share in March 2000. These days, its trailing 12-month
earnings per share are almost four times as high as they were
back then. Yet Cisco’s share price has collapsed to around
$23. What changed? The earnings multiple. Investors happily
paid more than 200 times earnings for the stock back in 2000,
whereas they are willing to pay only 13 times these days.
40
1999
TIME DOESN’T HEAL ALL WOUNDS
The lesson? Disparities between countries, sectors and
companies are huge. As a result, different exposures can
translate into radically different returns.
Return Drivers
LOW RATES = LOW RETURNS
Real Returns and Real Rates, 1900–2012
Corporate profit margins often expand in inflationary
periods. When inflation is rising, companies usually pass on
higher input costs to consumers by raising prices (and their
nominal debt loads are inflated away). Corporate revenues
tend to rise at a faster clip than expenses because most
companies do not like to raise wages. This is bad news for
employees but good news for equity holders—up to a point.
As inflation takes off, investors usually become less willing
to pay up for future earnings (price-to-earnings multiples
contract). Hard assets such as real estate perform better in
these environments, and equities suffer losses. The sweet
spot for equity returns? Inflation of 2%–3% or lower.
inflation hurts
Real Returns and Inflation, 1900–2011
20%
20%
18
8
0
0.6
1.9
2.9
10
4.5
0
-3.5
-10
-10
DEFLATION
-20
-26
INFLATION
Bonds
INFLATION RATE
REAL RETURN
10
-20
Equities
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and
Credit Suisse Global Investment Returns Yearbook 2012.
Notes: Study includes 19 countries and 2,128 country-year observations. Inflation levels
are minimums and in percentiles of the range over the period. The top and bottom 5%
occurrences are at the extremes while the remainder is grouped in percentiles of 15%.
9.4
5
4.8
10%
5
2.9
1.5
0
0
0.1
-2.2
-5
-5
LOW
REAL RATES
REAL INTEREST RATE
Bonds are hit even harder by inflation (with the exception
of bonds whose principal or yield is tied to inflation). This is
because bond coupons and principal are fixed and do not
adjust to compensate investors for any losses in purchasing
power. Equities have comfortably outperformed bonds in all
inflationary environments over the past century—and even
in periods of mild deflation.
FUTURE 5-YEAR REAL RETURNS
10%
High or sharply rising inflation is the enemy of equity (and
bond) markets. Equities have averaged a real annual loss of
12% since 1900 whenever inflation averaged 18% or more.
See the chart below.
HIGH
-10
-10
-11
Bonds
Equities
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Yearbook 2013.
Notes: Returns are annualized over the subsequent five years. Study includes 19
countries and 2,160 country-year observations. Real interest rates are minimums
and in percentiles of the range over the period. The top and bottom 5% occurrences
are at the extremes while the remainder is grouped in percentiles of 15%.
Equities have averaged real returns of more than 10% in
deflationary periods, the bottom chart shows. One caution:
Most of these instances took place in the prewar period
and were extreme. For example, nominal returns on UK
equities were flat in 1921. Yet investors ended up with a
35% real gain due to severe deflation, LBS data show.
Recent history shows some very different results. Take
Japan. The Nikkei 225 Index is still 65% below its 1989
peak in nominal terms and Japanese policymakers have
been battling bouts of deflation since the late 1990s.
Caution is needed in interpreting these results, too.
Japan’s equity market has descended from sky-high
bubble era valuations (showing the importance of both
valuations and the right entry point).
Interest rates are another key to equity returns. Equities
tend to post strong returns in the five years after high real
interest rates. See the chart above. One reason: Equities are
much more risky than government bonds. This means they
have to offer a premium over the inflation-adjusted “riskfree” rate to entice investors. (They have to offer compelling
value.)
The higher the risk-free rate, the higher the hurdle for
equities (and vice versa). Periods of low real interest rates,
by contrast, often coincide with high inflation (but not
always, as we have seen in recent years).
Pat t e r n s i n E q u i t y R e t u r n s
[7]
So how can investors decide in which countries to invest?
Let us start with one (discredited) strategy: Buy equities of
the fastest growing economies. Intuition tells us faster
growth should equal higher returns on equities. History tells
a different story.
Since 1900, the countries with the slowest trailing GDP
growth have delivered the same returns as the ones that
grew at the fastest clip. See the chart on the right. This
counterintuitive trend has been even stronger since 1972.
Nominal annual returns averaged 25% a year in the slowestgrowing economies, compared with 18% in the fastest.
Stocks in middle-of-the-road economies fared the worst.
hy? The equities of the slowest-growing countries are
W
often shunned—just like out-of-favor value stocks that tend
to subsequently outperform. By contrast, investors are often
willing to pay a premium for (expected) growth. Similar to
growth stocks that are “priced for perfection,” equities of
fast-growing countries can get overheated. Betting on
growth alone often does not work because markets have
already factored in economic performance. Only surprise
growth will likely affect returns.
ast-growing emerging economies are capital hungry.
F
Their bond markets are immature, so new (and existing)
companies must issue shares to raise capital. This dilutes
existing shareholders and tends to lower returns.
lobalization means bellwethers in slow-growing economies
G
(think Toyota) can boost earnings even while their domestic
economy is sluggish. Similarly, companies in some country
indices represent only a small portion of the economy (think
emerging markets).
The level of economic growth may have little impact on
equity returns in the long run, but its direction (expansion
versus contraction) matters in the short term—especially in
combination with inflation. The sweet spot for (monthly)
developed equity performance has been a combination of
Higher Growth, Lower Returns
Equity Returns by GDP Growth Quintile, 1900–2009
25%
20
ANNUAL RETURN
OF tortoises AND HARES
15
10
5
0
LOW
HIGH
LOW
19 Countries
1900–2009
HIGH
83 Countries
1972–2009
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Yearbook 2010.
Note: Countries are divided into quintiles by trailing five-year GDP growth rates.
global economic expansion and declining US inflation in
the past 25 years. For emerging market stocks, falling
inflation has been the key driver. See the table below.
The interaction of growth, inflation and other
macroeconomic factors on asset prices can have surprising
results—especially in the short run. US government bonds,
for example, have tended to perform well in months of rising
inflation since 1988. One reason: US inflation was subdued
throughout the period. In addition, global quantitative easing
by central banks in recent years has kept bonds well bid.
Bottom line: Growth is good for equities—but is often
priced in fast. Growth can affect equity returns,
depending on the time horizon, the type of growth signal
and the interplay with related factors such as inflation.
SHORT-TERM SURPRISES
Monthly Asset Returns in Various Growth and Inflation Scenarios, 1988–2013
Growth
Developed Emerging
Equity
Equity
US Gov.
Bonds
US IG
Bonds
US High
Yield
US MBS
Energy
Gold
US Cash
0.52%
0.94%
0.66%
0.28%
0.6%
2.49%
0.69%
0.34%
1.57%
1.56%
0.43%
0.62%
1.25%
0.43%
1.09%
0.33%
0.28%
38
-0.66%
-0.80%
1.16%
0.74%
0.55%
0.76%
-1.97%
-0.46%
0.41%
54
0.62%
2.25%
0.70%
1.14%
0.93%
0.65%
-0.53%
0.78%
0.31%
Inflation
Occurrences
Expanding
Rising
112
-0.07%
Expanding
Falling
101
Contracting
Rising
Contracting
Falling
Source: BlackRock Investment Institute, June 2013.
Notes:Rising or falling inflation is defined by a trailing three-month average change in the US Consumer Price Index. Expanding or contracting growth is defined by the monthly level of
the JP Morgan Global PMI Manufacturing Index. Data through May 2013. Returns based on indices from MSCI, Ibbotson, Merrill Lynch, Standard & Poor’s and Bloomberg.
[8]
R I SK AN D R ES I L I ENCE
The power of dividends has been drilled into investors’
minds. Reinvested dividends make all the difference in
equity returns over the (very) long run, many studies show.
Returns on equities can be split into three components:
dividend yield, divided growth (after inflation) and multiple
expansion (the increase in the price investors are willing to
pay for earnings or dividends). Dividends usually increase
over time, in line with corporate earnings and cash flows.
Outcomes across countries vary significantly, but overall
dividends have accounted for four-fifths of equity returns
since 1900. See the chart below.
Yet there is a rub: Equities are volatile. Market swings can
swamp the impact of dividends in any single year—many
times over. Many investors don’t have the luxury or patience
to wait decades for their dividends to compound. In
addition, companies reinvest their capital to boost growth
(some more successfully than others). Google has
increased its share price around tenfold since it went
public in 2004—without paying a cent in dividends.
Take a simple example of a portfolio of two $100 stocks.
One pays no dividend and rises 10%. The other has a 5%
payout but drops 10%. The total return on this $200 portfolio
is 2.5%—with the dividend yield equaling 100% of the return.
Yet which stock would you rather have owned?
DIVIDENDS DOMINATE—IN THE LONG RUN
Composition of Annualized Equity Returns, 1900–2012
5%
4.1%
4
3
2
1
0.4%
0
0.5%
-1
Dividend Yield
Real Dividend Growth
World
S. Africa
US
Australia
New Zealand
Canada
UK
Japan
Switzerland
France
Germany
Italy
Austria
-2
Multiple Expansion
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Sourcebook 2013.
Notes: Multiple expansion measures the change in the price-to-dividend ratio.
explanatory power
Contribution to Rolling 5-Year MSCI World Returns, 1996–2012
SHARE OF RETURN
dividend and rule?
100%
Dividend Yield
80
Multiple Expansion
60
40
20
Earnings Change
0
1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: BlackRock Investment Institute, June 2013.
Note: Measures contributions of growth in earnings per share, change in the priceto-earnings ratio and dividend yield to returns over rolling five-year periods. With
contributions by Steve Satchell of Trinity College Cambridge.
EARNINGS REALLY RULE
Fundamentals—metrics that gauge corporate
performance—usually win in the medium term. Changes
in corporate earnings explain around two-thirds of relative
stock performance in the MSCI World Index since 1996
measured over five-year periods, our research shows.
Dividends explain just a small sliver. See the chart above.
Equity valuation is not all about earnings. It is also about
how much investors are willing to pay for those earnings.
When investors are feeling exuberant, they are often willing
to pay more for stocks (and vice versa). The multiple
expansion (or contraction) explains half of the MSCI World’s
performance in some five-year periods.
This makes life a bit more complicated for equity investors. It
is hard enough to correctly forecast a company’s earnings. It
is near impossible to predict the mood of investors and how
much they will be willing to pay for a company’s earnings in
the future. Multiples can contract across the board in periods
of risk aversion. Even companies with strong fundamentals
are punished then—at least temporarily.
Yet even when investors awarded many companies rich
valuations in the late 1990s, changes in earnings still
accounted for the majority of returns over five-year periods.
The recent bull market has been underpinned by a steady
rise in earnings, as the chart shows.
Conclusion: Dividends account for just a fraction of equity
returns over (relatively short) periods of five years. Earnings
trends and shifts in market sentiment are the real movers.
Pat t e r n s i n E q u i t y R e t u r n s
[9]
FLUMMOXED BY FX
RISING FROM THE BOTTOM
Foreign exchange swings can make all the difference in
equity returns—especially in the short to medium term.
The currency impact takes place on two levels:
Changes in corporate debt levels and servicing costs can
also influence equity returns. Equity holders are at the
very bottom of the capital structure, giving them a claim
on corporate cash flows only after all creditors have been
paid off. The value of the equity claim rises if the company
reduces obligations to debt holders.
1.When investors hold foreign assets, currency fluctuations
will affect returns in their base currency. UK equities, for
example, have gained 41% over the past five years. Yet
the return was just 19% for US dollar investors as the
British pound steadily fell over the period.
2.Currencies also directly influence asset prices. A strong
US dollar, for example, tends to hurt emerging market
assets, as detailed in What’s Developing in April 2013.
Currency movements can also affect corporate earnings
and valuations. A strong yen, for example, has historically
hurt Japanese equities.
How does this work in practice? Consider some recent
history. Companies have been strengthening their balance
sheets and reducing leverage since the 2008 financial
crisis. The net debt of S&P 500 companies, for example,
has fallen 61% in the period. See the table below.
CAPITAL STRUCTURES
S&P 500 Metrics and Global Credit Maturity, 2003–2013
The impact of exchange rate swings appears to subside in
the long run as currencies adjust to relative inflation rates.
Annualized local equity returns have not differed markedly
from US dollar returns in real terms since 1900, LBS data
show. The reason: Real exchange rates averaged a change
of less than 1% a year versus the US dollar in the period.
To hedge or not to hedge? There is no clear-cut answer.
Considerations include:
}The investment horizon is key. Currency exposure
appears less risky in the long run than in the short term.
}Currency risk can be greatest in the medium term, if recent
history is any guide. Currency fluctuations contributed an
average of 14%-16% to equity risk across 27 countries in
rolling periods of up to 2 years since 2001, our research
shows. Yet over five- and 10-year rolling windows, they
averaged 27% and 21%, respectively. Caution: The benefits
of hedging on average disappear after 8 years when using
longer data series (40 years or more), LBS research shows.
}There is a cost to hedging—which adds up over time.
Hedging where you need it most (in emerging or illiquid
markets) is often expensive.
}Hedging is not not always the most effective way to
reduce currency risk. Diversification through holding
assets in multiple currencies can reduce volatility.
[10]
R I SK AN D R ES I L I ENCE
2003
2008
2013
Free Cash Flow
$45
$68
$112
EBITDA
$134
$211
$203
Book Value
$341
$530
$680
Net Debt
$642
$977
$383
P/E Ratio
20
17
16
8.5
MATURITY IN YEARS
Australian equities, for example, generated annualized real
returns of 7.3% from 1900 to 2012, LBS data show. The
Australian dollar gained an annual 0.12% against the US
dollar over the same period, so the total return to a US
investor would have been 7.42%. Yet over shorter time
periods, the currency impact can be crucial. Consider the
Aussie moved 45% in nominal terms from peak to trough
against the US dollar in the past five years.
S&P 500 Metric
8.25
8
7.75
2009
2010
2011
2012
2013
Sources: BlackRock Investment Institute and Bloomberg, August 2013.
Notes: The S&P 500 metrics are per share as of the end of June each year. The
average corporate bond maturity is represented by the corporate credit component
of the Barclays Global Aggregate Index.
With less debt on their books (and interest rates at
historically low levels), companies are spending less on debt
service—and have more left over to pay shareholders in the
form of share buybacks and dividends. Companies have
also been refinancing much of their debt (cheaply), pushing
maturities further into the future. See the chart above. This
has the potential to enhance shareholder value.
Similarly, companies (and equity returns) have to be
viewed in conjunction with the economy. If governments
spend freely (as many have done since 2008), corporate
cash flows and margins can get a boost. This virtuous
circle may reverse when governments tighten their belts.
Complication:
Correlations
Correlations spiked. Irish and Italian equities traded
with a weekly correlation of 90% in the one-year period.
See the table below.
Diversification—across different sectors, companies
and asset classes—can lessen volatility. The problem:
When investors need diversification most (during financial
crises), correlations tend to rise sharply.
Asset prices moved in lock-step, often in violent “risk-off/
risk-on” swings during and in the aftermath of the global
financial crisis. This pattern dominated global markets until
signs of a shift emerged this year, as detailed in Exit, Entry
and Overshoot in June 2013.
When equities, credit markets, commodities and
currencies collapse at once (as they did in 2008), even
diversified portfolios will likely stomach losses. The
financial crisis showed real diversification is tough
to come by.
Another simple, but often overlooked point: High
correlations between two sectors or asset classes do not
necessarily mean similar returns. Highly correlated assets
can rise and fall pretty much in tandem—but the result of
these moves can be very different over time. Correlation is
not causation.
The equities of Greece and other European peripheral
markets are a good example. Investors deserted these
markets in droves in 2011 on worries these nations could
not refinance their huge debt loads.
Yet their performance was vastly different. Irish stocks
declined just 3.3%, while Italian stocks collapsed 37.5%.
See the line chart below. Neighbors Portugal and Spain
had a lower correlation of 82% over the same period, but
their equity markets posted almost identical returns.
The conclusion: Correlations can be misleading in
predicting returns. They show direction, not magnitude.
IT’S COMPLICATED
Correlations can also change dramatically over time.
Correlations between US large cap equities have ranged
from less than 10% to more than 50% over the past three
decades. They hit the lowest levels since 2007 this year. See
the left chart on the following page. The trend was even
more pronounced in global markets: Correlations on the
MSCI World recorded 7%, also a six-year low.
Surely this must be a great time for stock pickers?
Fundamentals such as corporate earnings reign supreme
when equities are not moving in lockstep—and positive
earnings are usually rewarded with higher share prices. Know
your companies, and you will outperform, the theory goes.
The reality is a little more complicated. Low correlations
do not necessarily translate into a wider dispersion of
returns than in other periods, our research shows. And
high correlations do not herald a bunching up of returns.
The reason? Periods of market stress (and high
correlations) are usually characterized by outsized returns.
CORRELATION DISCONNECT
European Equities: Correlations and Cumulative Returns, 2011–2012
Italy
Spain
Greece
Portugal
Italy
Spain
Greece
Portugal
100%
90%
86%
50%
71%
90%
100%
95%
55%
81%
86%
95%
100%
51%
82%
50%
55%
51%
100%
55%
71%
81%
82%
55%
100%
Ireland
0%
Portugal
-20
tOtAl REtuRN
Ireland
Ireland
Italy
-40
spain
-60
Greece
-80
Jul 2011
Jan 2012
Jul 2012
Sources: BlackRock Investment Institute and Bloomberg.
Notes: Country returns are in euros and based on respective MSCI indexes for each country. Correlations are based on weekly returns and measured over the period July 1, 2011, to July 6, 2012.
Pat t e r n s i n E q u i t y R e t u r n s
[11]
STOCK PICKERS WELCOME
Correlations and Return Dispersions of US Large Caps, 1989–2013
Median Return
HIGH
50%
CORRELATION
CORRELATION
40
30
20
LOW
10
0
-20
1989
1995
2001
2007
2013
0
20
40%
DISPERSION OF 12-MONTH RETURNS
Sources: BlackRock Investment Institute, Russell Investments, IDC and Thomson Reuters, August 2013.
Notes: Chart shows the average correlation of pairs of stocks in the Russell 1000 over a 12-month window. Data are monthly through July 2013 and equal weighted. The bars on the
right chart represent the interquartile range, or middle 50%, of 12-month Russell 1000 stock returns in each correlation decile over the 1989­–2013 period.
When correlations of Russell 1000 stocks were highest in
the past 25 years, dispersion (in the interquartile range—
the middle 50%) was actually at its widest. See the right
chart above. This means active investors cannot blame
high correlations for poor (relative) performance.
ADDING RISK … BUT STAYING SAFE
A FREE LUNCH?
Return-to-Risk Ratio for UK Equity/Bond Portfolios, 1899–2012
RETURN-TO-RISK RATIO
.33
.23
ALL BONDS
50/50
ALL EQUITIES
.13
Sources: BlackRock Investment Institute and Barclays Capital, August 2013.
Notes: The chart shows the annualized risk-return ratio for various blended gilt/equity
portfolios over five-year periods. The ratio is derived by dividing the portfolio’s annualized
return by the annualized volatility.
[12]
R I SK AN D R ES I L I ENCE
More correlation food for thought: The dispersion of returns
is pretty stable regardless of the level of correlations
between different companies. In other words, good stock
pickers should be able to outperform regardless of the
market environment—in theory, at least.
Literature about asset allocation could fill the (classical)
Alexandria library. We limit ourselves to one simple
point: Even conservative investors can benefit from
adding some equities to their portfolios. Take a UK
investor with a portfolio invested 100% in gilts.
Allocating a moderate portion to equities would have
increased returns without adding much volatility over
the past century. See the chart on the left.
The reason? Equities and bonds tend to move in
opposite directions. This helps smooth the ride for
investors. A caveat: Correlations between asset classes
are not static. If bonds and equities start moving in
lockstep (as they did from the late 1960s through the
early 1990s), the portfolio suddenly looks a lot more
risky. The benefits of diversification also fade as the
equity portion rises: Risk-adjusted returns hit a ceiling
once equities made up more than half of the portfolio.
The Curious Case
of Low Beta
the VOLATILE MILLENnIUM
Annual Returns and Volatility, 2000–2013
10%
Emerging Market Debt
When stocks rise, investors forget just how volatile equities
can be. They are rudely awakened every once in a while
(usually when the consensus says equities are a sure thing).
The new millennium dealt investor psychology not one, but
two blows: two market crashes with peak-to-trough losses
of more than 40% (the collapse of the tech bubble and the
global financial crisis).
Many investors ran for the (apparent) safety of bonds.
Cumulative money flows into US fixed income funds and
exchange-traded products have exceeded flows into US
equities by a factor of 2.4 since 2005. See the chart below.
The real story has been a $1.3 trillion outflow from US money
market funds since risk assets hit bottom in early 2009 and
rates headed mostly lower, as detailed in Forget Rotation:
Think Risk Mitigation in February 2013.
US bond funds attracted $1.2 trillion over this period
whereas equities drew a measly $234 billion. This is why the
current equity market rally—which saw the S&P 500 more
than double from its 2009 lows—does not feel like a bull
market: Many investors missed the boat.
BONDS RULE(D)
Cumulative Money Flows Into US Funds, 2005–2013
6
US High Yield
Emerging
Market Equity
Inflation-Linked Debt
Global Investment Grade Bonds
4
Developed Government Debt
Developed Market Equity
US Cash
2
0
5
10
15
20%
ANNUAL VOLATILITY
Source: BlackRock Investment Institute and Bloomberg, July 31, 2013.
Notes: Nominal returns. Based on benchmark indexes from MSCI, Barclays,
Citigroup and JP Morgan.
A LOST DECADE?
Who can blame disillusioned equity investors? Developed
market equities have delivered paltry annual returns of
just 3.5% since 2000—barely enough to keep pace with
inflation. See the chart above. Equities underperformed
every major bond market over the same period.
Even worse: Equities were far more volatile. Developed
market stocks, for example, notched average volatility of
17% a year. Only emerging market stocks were more volatile,
but only by less than one percentage point.
By comparison, the riskiest bond market sector (emerging
market debt) delivered annual returns of 10%, with just half
the volatility of developed equities. US high yield bonds
delivered double the annual return of developed stocks at
less than a third of the volatility. The result: Many investors
lost faith in equities.
money market
$1,500
1,000
Fixed Income
billiONS
ANNUAL RETURN
8
equity
500
Shift the time period, and the case for equities looks much
stronger. Equities had comfortably outperformed 10-year
government bonds in both the United States and the UK
over periods of 1, 3, 5, 10, 20 and 30 years by the end of
August 2013. US equities beat Treasuries by 37 percentage
points in the last decade, while UK stocks outperformed
gilts by 53%.
How is that for a lost decade in stocks?
0
2005
2007
2009
2011
2013
Sources: BlackRock Investment Institue and Investment Company Institute (ICI),
July 31, 2013.
Notes: Combines cumulative flows into actively managed US funds (ICI data) and
into US-listed exchange traded products (BlackRock data).
It underscores the importance of the right entry point—as
well as the dangers of focusing on standard return periods
(or track records).
Pat t e r n s i n E q u i t y R e t u r n s
[13]
Volatility is rarely enjoyable. Markets tend to climb slowly
and steadily—but fall with a thud.
Equities have always been more volatile than bonds, but
have generated enough returns to compensate investors
for the anxiety. Risk-adjusted US equity returns (excess
returns divided by volatility) consistently beat those of
bonds from 1960 to 2000. See the chart below. This was
especially true in the 1970s, when bonds were slammed by
double-digit inflation.
The trend reversed in the new millennium, with bonds
recording superior risk-adjusted returns. Investors
took notice. Low returns are bad. Low returns with high
volatility are worse. New regulations also encouraged
financial institutions to minimize asset volatility, making
it harder to maintain large equity allocations.
Pension funds have shuffled more money into bonds over
the past decade. European pension funds have reduced
their equity allocations to below 40%—the lowest level
in at least 10 years, according to consulting firm Mercer.
Bonds provide greater certainty of future cash flows,
making them ideal for matching long-term liabilities.
But it is not a one-way street for bonds. With interest
rates near record lows, bond yields had only one way to
go: up (and prices down). Equities looked poised to start
offering better risk-adjusted returns.
RETURNS THAT REALLY MATTER
Risk-Adjusted Returns of US Equities and Bonds, 1959–2013
1.5
SHARPE RATIO
60%
40
20
0
-10
1973
1983
1993
2003
2013
Sources: BlackRock Investment Institute and MSCI Barra.
Notes: The chart shows the difference in cumulative return between the top 10
and bottom 10 beta industries in the MSCI Barra US Equity Model over the period.
Industries without full histories are excluded. The gold and oil services industries
are excluded from the low-beta basket because their volatility exceeds the broad
market’s. Monthly data through May 31, 2013.
BONDIFICATION
Equity market volatility not only sent many investors
scurrying for the safety of bonds; it led some to reshuffle
their equity allocations as well. Investors flocked to
dividend stocks, defensives and “quality” equities with
steady earnings and low volatility.
This “bondification” of parts of the equity market led to
stark performance differences. The minimum-volatility
counterparts of equity indices outperformed their plainvanilla peers—with much lower volatility. See the chart on
the left of the next page.
0.5
0
The new mantra of equity investing became:
Low risk = high return.
-0.5
US Bonds
-1
1959
1970
1980
1990
2000
2010 2013
Sources: BlackRock Investment Institute, Kenneth French and Federal Reserve
Bank of St. Louis.
Notes: Total returns in five-year rolling Sharpe ratios. Returns are annualized
and minus the yield on three-month US Treasury bills. Bonds are represented by
10-year US Treasuries. Equities are represented by the Fama/French model.
Data through June 30, 2013.
[14]
Cumulative Excess Return of Low-Beta US Equities, 1973–2013
Low-volatility, or “low-beta” strategies outperformed
more volatile equities. Excess returns from the first group
accelerated in the new millennium. See the chart above.
US Equities
1
LOW BETA WINS—FOR NOW
CUMULATIVE RETURN
VOLATILiTY BLUES
R I SK AN D R ES I L I ENCE
This poses a conundrum for standard investment thinking.
Theory says the expected return of an equity should be
proportional to its risk over time. Riskier (or “higher-beta”)
equities should offer investors greater returns over time to
compensate for their higher volatility (and vice versa).
Yet the investor experience has been different—at least in
recent times.
Why has taking risk not paid off? The bondification of the
equity market is part of the answer. In periods of large
interest rate changes, relative repricing of low- and highvolatility strategies may drive performance. We can think of
this as a kind of “equity duration.”
Consider two hypothetical companies: an oil explorer and an
electric utility. The oil explorer offers a risk premium (after
inflation) of 10%, compared with 2% for the utility. The
explorer has a big potential payoff if it strikes oil—but this is
a big “if.” The regulated utility offers more predictable cash
flows, but much lower returns.
THE REAL MULTIPLIER EFFECT
Hypothetical Stock Performance as Rates Decline
$400
utIlIty
real risk Premium=2%
PRiCE OF SECuRity
EXPLAINING THE UNEXPLAINABLE
300
Real RIsk-FRee Rate DeclIne
200
oIl exPloReR
WHEN RISK DOESN’T PAY
real risk Premium=10%
Minimum Volatility Indices, 2003–2013
20%
100
ANNUALIZED PERFORMANCE
MSCI EM
Minimum Volatility
6
15
MSCI
Emerging Markets
5
4
3
2
1
0%
Source: BlackRock Investment Institute, August 2, 2013.
Notes: Hypothetical utility with a real risk premium of 2% and oil explorer with a
real risk premium of 10%. For illustrative purposes only.
What happens when interest rates rise?
10
S&P 500
Minimum Volatility
MSCI Europe
Minimum Volatility
MSCI
Europe
MSCI World
Minimum Volatility
MSCI
World
5
10
15
S&P 500
20
Low-beta plays could become a lot tougher—and less
rewarding. Volatile assets could once again start
compensating investors for the additional risk (and anxiety)
they take on.
powered by rates
25%
US Utilities Price-to-Book vs. S&P 500, 1997–2013
ANNUALIZED VOLATILITY
90%
Sources: BlackRock Investment Institute, MSCI and Standard & Poor’s.
Notes: Data from June 28, 2003, to June 28, 2013. Total returns and volatility are
annualized and in US dollars.
This is not just theory. The valuation of US utilities
(represented by the price-to-book ratio) has moved in the
opposite direction of real interest rates since 1997. See the
chart on the bottom right.
A shift in the risk-free rate is an afterthought for the oil
explorer. The most important driver of this company’s stock
is whether or not it strikes oil. (Unless the explorer carries a
huge debt load: Debt becomes cheaper to finance and easier
to roll over when risk-free rates drop.)
80
RELATIVE PRICE-TO-BOOK RATIO
When interest rates decline (making it harder to earn
attractive income from bonds), the utility’s stable cash flows
become more valuable. Investors bid up the utility’s shares in
a grab for yield. See the chart on the top right.
Jun 30, 2008
70
60
Jul 31, 2013
50
40
Dec 31, 1999
30
-1
0
1
2
3
4
5%
10-YEAR TIPS YIELD
Sources: BlackRock Investment Institute and Bloomberg, August 2013.
Notes: The relative price-to-book (P/B) ratio is the P/B of US utilities divided by
the P/B of the S&P 500 Index. Real rates are represented by the yield on 10-year
Treasury Inflation-Protected Securities (TIPS). Monthly data through July 31, 2013.
Pat t e r n s i n E q u i t y R e t u r n s
[15]
Why BlackRock
BlackRock was built to provide the global market insight, breadth of
capabilities, unbiased investment advice and deep risk management
expertise these times require. With access to every asset class, geography
and investment style, and extensive market intelligence, we help investors of
all sizes build dynamic, diverse portfolios to achieve better, more consistent
returns over time.
BlackRock. Investing for a New World.
BLAckrock investment institute
The BlackRock Investment Institute leverages the firm’s expertise across
asset classes, client groups and regions. The Institute’s goal is to produce
information that makes BlackRock’s portfolio managers better investors
and helps deliver positive investment results for clients.
Executive Director
Lee Kempler
Chief Strategist
Ewen Cameron Watt
Executive Editor
Jack Reerink
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