Tristan Hanson, head of asset allocation at Ashburton, explores the correlation between expectations of returns and expected returns.
Investing is a counterintuitive exercise. Things that seem obvious are typically anything but, or at least waging money on their outcome is rarely profitable – the seemingly certain scenario is priced in and the risk of an alternative outcome under-priced.
Future investment returns will generally be low when starting point valuations are high, yet it will be under circumstances that look and feel rosy that such commentators will argue high valuations are sustainable.
Similarly, the greatest returns are generally made when the outlook seems most dreadful and the thought of putting one’s hard-earned cash into the market is most gut-wrenching.
Research touched upon in a recent speech by Federal Reserve board of governor’s member Jeremy Stein highlights the difference between “expectations of returns” and “expected returns”.
The authors find a strong correlation between what investors say they expect stock markets to deliver in terms of future returns and model-based expected returns – only the correlation is negative.
In other words, when investor expectations of returns are high, subsequent returns are generally low. These expectations tend to be formed by extrapolating recent returns and are the explanation why the market sometimes trades on lofty valuations. Investor expectations are also positively correlated with mutual fund flows.
In this light, it is interesting to note that, after a four-year period of strong gains in global equity markets, retail fund flows into equities have picked up in 2013; their strongest run for nine years, according to Bank of America Merrill Lynch (BoAML). At the same time, selling by corporate insiders has picked up, according to ISI.
While retail fund flows attract much attention, particularly when they are strongly positive or negative, there is little thought given to the fact that, in any transaction, for every buyer, there is a seller.
Corporate insiders were buyers of equities in late 2008 and early 2009, and again in mid-2011 when retail investors took flight. Could we be starting to see a shift in the ownership of equity by investor type?
It is also apparent that nearly everyone seemingly favours equities over fixed income assets at this point in time, with some commentators arguing a “great rotation” will occur driven by a large allocation switch from investors. This consensus view is reflected in a number of sentiment indicators pointing to elevated levels of optimism.
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