“Probable Outcomes” by Ed Easterling
In a nutshell
In “Probable Outcomes” Ed Easterling makes his heroic pitch for active investment management in periods of “secular bear markets”. While I did enjoy the book (lots of historical data and insightful analysis, but no how-tos for achieving success in the holy grail of active management) he hasn’t made a sale to me. To me active investing, even after reading the book is a triumph of hope over reality for the simple reason that DIY investors can’t even hope to compete with the “pros” (in skill and resources if those could systematically make a difference), and handing over management to the “pros” means you have to pick the future winning managers, and those picked will have to beat the market in a sustained manner in excess of their fees to break even compared to a low cost index approach. I wouldn’t count on it. Still it was a quick and interesting read, even if at times it sounded like an advertorial for active management in general and absolute return funds in particular. My most important takeaway was to re-enforce the setting realistic return and withdrawal expectations, selecting appropriate asset allocations for risk control, rather than resort to active investment management. His messages: lower than historical returns (might come true) and superior outcomes with active management (unlikely).
Some of the more interesting observations pertain to:
-perhaps the principle theme running through the book is the importance of P/E in driving returns and measuring P/E in a normalized cyclical series (e.g. Shiller’s approach)…”a low P/E drives above average gains and higher dividend yields; a high P/E drives below-average gains and lower dividend yields. …”success periods required a rising P/E. The change in P/E over the investment period is the most significant driver of variability in stock market returns.”
-showing the impact of starting P/E at retirement on the likelihood of running out of money (ROOM) in less than 30 years using the “traditional” 4% draw per year plus inflation (even if no rational person would do that for 30 years without
adjustments as required along the way). Easterling’s interesting insight was that since 1900 for the 81 30-year periods of data available a 100% allocation to the S&P500 would result in only 4 instances of ROOM (i.e. 95% success rate), however all 4 failures occurred when at start of retirement P/E ratios were in the upper quartile or >18.7, resulting in only 76% success rate. In the case of 5% plus inflation scenario would result in overall success of only 75% but upper quartile (P/E>18.7) success rate would drop to 41%, while second (P/E= 15.1-18.6) and third (12.2-14.9) quartile success rates would only be about 70% (not recipes for success).
-“the main variables (of decumulation when one start with the assumption of a fixed initial withdrawal percent followed by annual inflation adjustments) are: (1) success rate, as reflected in the percentage likelihood of not running out of money: (2) portfolio mix and return assumptions for investment income; (3) how long the retiree assumes that he or she will live; and (4) a variety of other variables including tax rates, investment expenses. etc
-the public pension crisis as a result of systematic underfunding due to “whatever rate of return assumption they believe is appropriate” and then (the lunacy of) using “the discount rate for calculating the present value of liabilities…based on the composite return from the investments” (i.e. the more aggressive the pension plan portfolio, the higher the discount rate for liabilities…that is truly lunacy)
-arguments why the coming decade will have lower market (perhaps real 1-7%) returns that historical (scenario analysis of different growth and inflation rates) and arguments why we are still in middle of secular bear market primarily due to high P/E (currently we have high P/E and many expect rising/high inflation, which usually leads to secular bear market)
-“Rather than simply recovering the principal, investors should assess the probability of achieving the required or expected rate of return. Risk therefore, can represent the uncertainty of a shortfall in funding a projected liability”
-dividends historically about 45% of earnings, so “if the dividend yield D/P=2%, then P/D=50. When P/D is multiplied by the payout ratio of 45% the result is 22.5 can be used as estimated P/E to compare to reported and normalized P/E.”
-explanations of: Fama’s Efficient Market Hypothesis (EMH), Markowitz’s Modern Portfolio Theory (MPT), systematic (market) risk and non-systematic risk (company risk)
-portfolio of bonds and stocks is not necessarily diversified because “over longer periods of time, particularly during inflation, those two markets tend to move in the same direction”
-problems with assumptions underlying Monte Carlo simulations (when based on randomly sequenced historical returns); should factor in current valuation levels (P/E) and use historical periods of similar valuation as the set for simulation
-high inflation and deflation are both bad for P/E ratio; sweet spot is around 1-2%
-typical “rebalancing is the reallocation of assets from one or more asset classes to other asset classes as their relative value changes…(then the pitch) “investors can choose to approach rebalancing as allocations to the markets or as investments within the markets”…but ask yourself how much easier is to do the former than the latter and research has shown that the former (asset allocation) explains 90% of the performance differences between portfolios…so why would you want to do the latter rather than the former…it is much harder to do and has lower opportunity for payoff.)
-“Volatility matters over time because it diminishes compounded returns compared to average returns, (not just because sharp downdraft will force many investors out of the market at the bottom, but) because investors can only spend compound returns…(and) the difference between simple average gain and compounded average gain is significant for the stock market over the long term….as risk and the variability of return increase, the force of Albert Einstein’s eighth wonder of the world- compound interest- is diminished.” (also, significant negative returns during decumulation as opposed to accumulation, are aggravated by the fact that stocks are being sold rather than purchased at low prices and withdrawals further reduce asset base that will be available for future growth.)
-one of the key practical implications of data presented is the importance of “realistic expectation of (return and) lifestyle spending”…”the stock market is not a game of chance that relies upon longer periods (time diversification) to tip the odds in your favor, and the odds are not the same for all periods” and during secular bear markets investors should not avoid the stock market but instead perform an “enhanced level of risk management to complement return generation” (though only generalities of how one might do risk management is offered)
Some of the perspectives on which I wasn’t sold on were:
-that absolute return funds, active management and risk management to avoid failures.. “The terms “absolute” and “relative” refer to their respective benchmarks of success…“Absolute” return investing is assessed in relation to breakeven….”relative” return investing is assessed is assessed in relation to a (e.g. stock or bond) market….absolute return investing defines risk as the potential for a loss; the threshold for success in absolute return investing is profitability”. (There were no magic potions or incantations offered to do this…just trying to do better than the market on an after expense basis is insufficient…the market delivers the same returns to everyone, the cost of active management (management fees, transaction costs, taxes, etc can’t sustainably be overcome by generated excess return, if any)
-no proof of any kind that active management can add value…in fact on p.165 it says “had there been wrestling matches between Markowitz (Modern Portfolio Theory) and Graham (value based investing) in the 1960s or 70s, neither of them would have been a decisive winner, and across the secular bear market of that period, both may have been losers….(however) in the 1980s and 90s…the simplicity of passively managed portfolios, especially stocks and bonds, became the mainsail in the tailwinds of the secular bull market”. (So during bear markets, when you might expect that stock picking would be able to gain an advantage, it did not; however during the bull market the passively managed portfolio was the winner…oh well…)
Easterling’s messages are: coming decade’s returns will be lower than historical average (currently high P/E, lower growth, expected higher inflation) but you can do better with active management. Lower returns might come true, but superior outcomes with active management are unlikely.
(For those who think that absolute return investment and active management can add value, you might wish to read a couple of this week’s articles in the financial press: Chris Flood’s Financial Times “Absolute return funds ‘a myth’” and Ron DeLegge’s “S&P Report: Over 50% of active managers underperform”; and in case somebody tells you that hedge funds are the answer you may want to read Steve Johnson’s ” Also, in “hedge fund indices’ accuracy in question”. In the interest of full disclosure, I should mention that respected investor (originator of the concept of “fundamental indexing” which many say is not indexing but investing with a value tilt) Rob Arnott endorsed the book (but not active and absolute investing explicitly) with the comment that Easterling recognizes that “valuation and long-term secular trends have an immense impact on our own long-term investment success”.)