Edition: September / November 2015


Known unknowns

An undertone of political interventions contrasts with trustees’ primary duty.

I would like to make the following observations on your editorial ‘Expectations on a high’ (TT June - Aug):

Do trustees really need to worry about the current level of the stock market? After all, fund members with a short-term horizon should have low exposure to equities already; those with a longer-term perspective can ride out corrections, and those trying to time the market (speculators) deserve what they get.

Yes, the market’s valuation is above the historical norm. But the referenced ‘crocodile jaws’ - positive stock market returns in the face of slowing growth - tell only half the story. The market value depends not only on the forecast future cash flows, but also on the rate at which those cash flows are discounted.

Investors in our market have historically demanded a real (after-inflation) return from equities of around 7% pa. This return is based on a risk-free hurdle rate of 2% to 3% and an equity-risk premium of 4% to 5%. This required real return is observed rather than specified. It can be seen in the long-term real return delivered by listed equities in SA or derived from the long-run average earnings yield of the SA stock market.

Investors have earned much more than 7% pa in recent years. Some of this stems from our market’s rerating which has been driven by the erosion of the riskfree rate globally. This lowers the hurdle rate for equity investors. Future cash flows then become more valuable, even if they are not expected to increase that fast. Stuck in this phase of low growth, low (ish) inflation and low real interest rates, investors have looked to equities for a real return. If it persists, we would expect equity returns to moderate but not necessarily turn negative in a big way.

Ironically, signs of an accelerating economic recovery will be bad news for share investors. It suggests that real interest rates will rise, along with the discount rate applied to future cash flows. Although these cash flows may improve as the economy grows, they will become less valuable. We would then expect a degree of mean reversion, and for the share market to give back some of its gains.

We can also envisage a less benign scenario, where real interest rates increase on the back of rising inflation rather than economic growth. The effect on our share market would then be much more severe.

We have no idea which scenario will play out. The market may also succumb to another crisis - as it does from time to time - but no one can predict when this will happen either. Market timing is a speculative pursuit that has caused many retirement funds to lag their strategic benchmark in recent years. Some providers have a strong vested interest in a market correction.

Rather than speculate on the future return, trustees should make the asset-allocation decision based on their members’ investment time horizon. They should find the most effective and cheapest way to own these asset classes and diversify adequately. They should stick to the plan and re-balance in a disciplined manner. Above all, they should ignore what investment “experts” have to say on the current market level and what the future holds in store, because these experts– like the rest of us – simply don’t know.