Do Expected Stock Returns Wear a CAPE? (EP.146)

Episode Summary

Executive Summary: In this episode of the Rational Reminder Podcast, hosts Benjamin Felix and Cameron Passmore discuss listener feedback, recent financial news (Archegos collapse, Madoff's death, a bizarre deli IPO), and the controversial article 'Could Index Funds Be Worse Than Marxism?' The main segment dives deep into modeling expected stock returns, analyzing historical data from Dimson, Marsh, and Staunton, and exploring the equity risk premium. They examine the challenges of using historical returns, the debate over return predictability, and present their own bootstrap simulations. The episode concludes with a 'bad advice of the week' segment critiquing a private credit investment pitch.

Main Topics: Listener Feedback and Community Updates (Priority: 2/5): Discussion of positive reviews, the impact of a controversial guest episode, expansion of the team for merchandise, and community engagement with Larry Swedroe. Recent Financial News and Events (Priority: 3/5): Coverage of the Archegos Capital implosion and its fallout on major banks, the death of Bernie Madoff, and the bizarre case of a New Jersey deli with a $100 million market cap but only $37,000 in sales. Index Funds and Market Power (Priority: 3/5): Analysis of the Atlantic article 'Could Index Funds Be Worse Than Marxism?' and the debate over whether index funds concentrate too much power and degrade market information. The hosts side with Adriana Robertson's view that there is insufficient evidence of a problem. Modeling Expected Stock Returns (Priority: 5/5): The core topic: a deep dive into the equity risk premium, historical returns, and methods for estimating future returns. Covers the equity premium puzzle, survivorship bias, and the work of Dimson, Marsh, and Staunton. Return Predictability Debate (Priority: 4/5): Examination of whether stock returns are predictable using valuation metrics like the CAPE ratio. Discusses in-sample vs. out-of-sample tests, the Goyal and Welch paper, and the limitations of regression analysis with overlapping data. Bootstrap Simulations and Country-Level Analysis (Priority: 4/5): Presentation of the hosts' own analysis using DMS data, including rolling historical periods, bootstrap simulations, and individual country outcomes. Compares the distribution of outcomes and the impact of incorporating predictability. Bad Advice of the Week: Private Credit (Priority: 2/5): Critique of an article promoting private credit as offering 'bond-like stability, equity-like returns.' Highlights red flags like downplaying risk, exclusivity pitches, and the use of leverage.

Key Arguments: Historical U.S. stock returns are biased upward due to survivorship bias and are not a reliable guide for future expectations. The equity risk premium is likely time-varying, influenced by changes in risk, risk aversion, and diversification ability. Return predictability from valuation ratios like CAPE is weak out-of-sample and may not be useful for market timing decisions. Bootstrap simulations, while ignoring mean reversion, produce a distribution of outcomes that aligns with the range of individual country experiences, suggesting they are not unrealistic. A reasonable forward-looking estimate for the geometric equity risk premium is around 3.5%, as suggested by Dimson, Marsh, and Staunton. Private credit pitches often use loaded language to downplay risks and create a false sense of exclusivity, warranting caution. Index funds are not a threat to market efficiency or corporate governance, as there is no strong evidence to support such claims.

Data Points: Historical World Index Equity Risk Premium (1900-2020): 4.4% - Geometric mean over U.S. Treasury bills. Historical U.S. Equity Risk Premium (1900-2020): 5.8% - Geometric mean over U.S. Treasury bills. Historical World Index Real Return (1900-2020): 5.2% - Geometric mean, inflation-adjusted. Historical U.S. Real Return (1900-2020): 6.6% - Geometric mean, inflation-adjusted. World Index Real Return (1900-1949): 2.7% - Annualized real return for the first 50 years. World Index Real Return (1950-1999): 8.6% - Annualized real return for the subsequent 50 years. Decomposition of Historical World Return: 4% dividend yield, 0.7% real dividend growth, 0.5% multiple expansion - Contribution to the total return over the full 121-year period. Dimson, Marsh, Staunton Forward-Looking Geometric Equity Risk Premium: 3.5% - After stripping out luck and repricing components. Arithmetic vs. Geometric Difference: 1.5% - Difference used to convert geometric to arithmetic expected return for Monte Carlo simulations. Archegos Loss at Credit Suisse: $4.7 billion - Hit from the family office's inability to meet margin requirements. Hometown International Market Cap: $101 million - Despite only $37,000 in sales over two years.

Pivotal Quotes: "It's not the notes you play, it's the notes you don't play." — Miles Davis (quoted by listener DragonFB): Listener review comparing the hosts' interview style to the famous jazz musician. "I always end up feeling like I've learned something that I can apply to my life." — Listener Elams: Listener review highlighting the podcast's practical value. "No, I'm not terrified that it's going to destroy liquidity in the markets. Or it's going to mean that we don't have price efficiency anymore, or corporate governance has gone out the window. None of these things, I think. I haven't seen any evidence to make me worry." — Adriana Robertson (quoted by Benjamin Felix): Response to concerns about index funds concentrating too much power.

Implications: Investors should temper return expectations, using a forward-looking equity risk premium of around 3.5% rather than historical U.S. averages. The wide range of potential outcomes, as shown by bootstrap simulations and individual country data, underscores the risk of relying on mean reversion. Be skeptical of investment pitches that downplay risk or promise 'equity-like returns with bond-like stability.'