A Lost Decade Looms: ‘Cheap By Proxy Isn’t Actually Cheap’

“Lost decade” warnings are becoming ubiquitous.

In some respects, the rationale behind calls for a prolonged period of low returns across multiple assets is so simple as to be barely worth mentioning. Everything is expensive. All else equal, when everything is expensive, common sense dictates the odds are skewed against additional large gains.

While it’s most assuredly true that stocks are relatively attractive, it sometimes seems lost on market participants that two things can both be expensive simultaneously. “A 25-year period of disinflation and nearly 40-year rally in bonds has left stock and bond prices at incredibly high valuation levels at the same time,” Macro Risk Advisors’ Dean Curnutt wrote, in a recent note. “The joint richness of stock and bond prices is near the 100th%ile,” he added.

Obviously, the percentile ranking depends on your look back, but the figure (below, from Goldman) underscores the point.

“Besides a worsening growth/inflation mix in 2022, investors will likely have to contend with relatively high valuations across assets,” the bank’s Christian Mueller-Glissmann wrote, in a year-ahead outlook piece with Cecilia Mariotti, Andrea Ferrario and Peter Oppenheimer. “Compared with historical early-cycle backdrops, valuations for equities, bonds and credit are already much more elevated, which creates a speed limit for returns from here.”

Similarly, BofA’s equity strategists reiterated in their 2022 outlook that the S&P’s current trailing normalized P/E ratio “suggests a 10-year annual 12-month price return of -1.3%, the first negative returns since the Tech Bubble.” The figures (below) are familiar.

“Valuation is almost all that matters for long-term stock returns,” the bank’s Savita Subramanian reminded clients.

Again, all of the above is relatively straightforward and it’s part and parcel of all “lost decade” calls. In one such warning, Goldman cautioned that 60/40 returns are likely to be “much lower” over the next decade even under a relatively benign set of assumptions.

Earlier this week, Mueller-Glissmann sketched the vexing quandary for investors who’ve become accustomed to the steady returns and diversification benefits associated with balanced portfolios over the past 20 years. “In the post-pandemic cycle the benefits from equity/bond diversification alone may not be enough to create a more attractive risk/reward compared with just holding equities (and cash),” he said, adding that although “the need for attractive real returns points to larger equity allocations, the key risk is the prospect of an equity bubble, which can weigh even on long-term returns.”

The good news is, the risk of a stock bubble is mitigated by suppressed long-dated real rates, but that immediately raises questions about what happens if real rates rise. And, as Goldman went on to concede, “in any scenario, higher equity allocations increase portfolio risk.”

The real challenge is coming to terms with the psychological distress associated with the distinct possibility that bonds (i.e., your risk-free asset) could become a source of risk and portfolio volatility. I’ve been over this countless times previous, but it’s impossible to overstate how important it is to grasp this particular point.

MRA’s Curnutt drew a parallel with 2007. “One market (mortgages then, Treasurys now) is facing a sweeping change in fundamentals (subprime defaults then, inflation, a creeping default, now) that has huge implications for other asset classes,” he said. This time, the “central risk” emanates from what he described as “the absurd pricing of the ‘risk free’ asset upon which everything else in the world is richly priced.”

Ultimately, it all comes back to assumptions about correlations. Recency bias (and the fact that stock-bond return correlations have been generally negative for the entirety of some folks’ careers) makes it difficult for market participants to imagine a world where the equity-rates correlation flips. That lack of imagination could be problematic.

“Institutional considerations have left the default portfolio construction as 60/40,” Curnutt went on to say, adding that “key to this preference is the notion that the risk of such a portfolio is mitigated by the stabilizing impact of bonds [but] a less optimistic take would be that stock prices are high because bond prices are high.”

He called that the “the ‘cheap by proxy’ argument,” on the way to explicitly stating what I’ve implicitly suggested on too many occasions to count. Namely that “cheap by proxy is not actually cheap.”