Remember absurd books like Dow 30,000 or Dow 36,000 or the eponymous Dow 40,000? In 2008, I labelled them "Five Books not to buy." Well somebody must be buying them because Dow 40,000 is implicitly what pension funds are expecting by the year 2030.
SocGen’s Andrew Lapthorne had a good piece out on this about this time last week called "Dow to 40,000 by 2030? US pension funds certainly seem to think so." Here’s what he said (emphasis in original):
‘Dow 40,000’ sounds like a crazy forecast and it is. But this is what many investors seem to implicitly expect, particularly in the US. Our models point to long-term equity returns being significantly lower.
- Storing up problems for the next generation seems to be a recurring global theme these days. One such problem is the overly optimistic returns expectations embedded within many corporate and state pension funds. We estimate US pension funds are factoring in a nominal 9% equity return in the long-term. In the UK it is some 100bp lower.
- How realistic are these expectations? Well if history repeats itself, following such a poor 10-year return period as we’ve experienced, on average the S&P 500 has delivered 11% real over the next ten years. However, given the sharp rebound in equity prices since March 2009, half of that gain is already behind us. An analysis of Shiller PEs and future returns also indicates average real returns of just 1.7% going forward.
- A decomposition of historical returns into building blocks also indicates that with US dividends yield below 2% and real dividend growth typically 100bps or more below trend GDP growth, an implied real return of 3% from US equities is a realistic assumption. But this is before deducting fees and trading costs.
- So why do investors expect so much more? Well in part the higher volatility of earnings growth relative to GDP and dividend growth gives the impression that higher growth is possible; optimistic consensus sell-side profit expectations don’t help either. Our calculations reveal that consensus 12-month forward earnings forecasts have overestimated S&P reported profits by $2.3 trillion dollar during the last 20 years. To put that number in context, during the same period the S&P paid out roughly $3 trillion in dividends.
- The reality is that current valuations still imply returns which are far below many investors expectations. This should clearly be a concern for both companies and governments going forward. It should however be no surprise to Warren Buffett, who said back in 2007: ‘What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire’.
Bottom line: a 9% equity return is highly unlikely when P/E ratios are still above trend. Lapthorne is talking 1.7% real returns. Moreover, the fixed income side isn’t looking any better with interest rates at record lows nearly everywhere. Pension assumptions are based on nominal bond yields that are equally unlikely to be met. Hence the need to buy Ghanaian 10-year bonds for 6.3% yield.
Right now, none of this is a concern. The recent piece Happy Days Are Here Again? captures the Zeitgeist. The liquidity seeking return mentality works until it doesn’t. And as Buffett notes, many hope to take a lot of profits in the form of bonuses and stock options by then. I wonder who will be left holding the bag when this all goes pear-shaped?