Unemployment in the United States is still over 9%. Growth of the global economy is slowing, according to various international GDP measures. European banks are mired in what looks like a liquidity crisis due to bad sovereign debt and . . . well, you're familiar with the list. In response, stock markets seem to be zigging and zagging lower rather than higher. So, what kind of return should investors "expect" from their stock portfolios in the face of such bad economic news?
Professors Eugene Fama (University of Chicago Booth School of Business) and Kenneth French (Tuck School of Business at Dartmouth College) answered this question in a short blog post dated March 11, 2009, which, in hindsight, was within days of "the" market low point following the 2007-2008 financial crisis. At the time, they wrote this:
"The market has declined sharply in response to rough times and forecasts of future rough times. The decline in market prices combines two effects: (i) lower current and expected future profits, and (ii) higher discount rates for the expected future profits. The discount rate, in turn, has increased because uncertainty about future profits (in other words, risk) has increased and, apparently, because investors have become more risk averse. Higher discount rates for expected profits translate into higher expected stock returns.
In short, the two of us believe that the expected return on stocks is currently high. But beware: the high expected return is compensation for the risks associated with different possible outcomes. If the quite pessimistic assessments of future economic performance built into current market prices turn out to be right (which is our best single guess), realized returns will be high. In other words, we will get the currently high expected return if the market's pessimistic expectations of future economic performance are realized. On the positive side, there is a substantial chance that the current assessments of future economic performance built into market prices turn out to be too pessimistic. If so, realized returns will be even higher than expected. But there is also a substantial chance that the current quite pessimistic assessments of economic performance built into market prices turn out to be too optimistic. In that case realized returns will be low, perhaps quite low. This is always the general nature of the risks in stock market investing. The story is more poignant at the moment because risk is so high."*
Professors Fama and French make three critical observations worth re-reading and considering in today's economic environment. The first is that investors have responded to bad economic news by demanding a higher return for stock investments. This demand for higher return (what Fama and French refer to as the "discount rate") results in lower prices being paid for a company's expected future earnings. Investors, as a group, currently think those earnings are at greater risk of declining. Interestingly, in 2011 so far, actual corporate earnings have been relatively strong.
The second key point is captured in the statement, "In short, the two of us believe that the expected return on stocks is currently high." Why? Neither professor believed then (or now) in market timing or in making predictions. They have written extensively about why these practices should not be trusted. What they were saying is that the decline in prices reflects a de facto increase in the risk premium demanded by investors. Any positive return from these lower prices, mathematically, must be greater than if the stock price rose from a previously higher price. For example an investor's percentage return on a stock rising from $10 to $20 is higher than it is on an increase from $15 to $20. In both cases, the stock rises to $20, but the investor who bought (or held) at $10 will get a 100% return while the investor who bought (or buys) at $15 will "only" receive a 33% return on investment.
Finally, their perspective on risk is extremely important. Risk does not guarantee higher return, but as risk increases, investors require the possibility of a higher return. Fama and French envisioned three possible outcomes in 2009; the expected outcome, the better-than-expected outcome, and the worse-than-expected outcome. None could then, or now, be guaranteed. Current market prices factor in the pessimistic economic news that is known by the universe of investors. So, when the professors say that the higher rate of return is their "single best guess", they are not suggesting they know more than the market. They are, rather, observing that this is now what the market expects. As a result, the market of all buyers and sellers was requiring lower prices for equities in March of 2009 than in late 2007. This same observation holds today in September 2011 relative to stock prices in June 2011.
In retrospect, 2009 and 2010 were years of very high returns for stocks around the world. This growth reversed direction in July 2011 as the European banking crisis became a larger issue and world economic growth slowed. Both of these circumstances increased the perceived risk of investing in stocks, driving prices lower. At today's lower price, expected returns have again risen. The risks are real, but patient investors have been rewarded in the past for participating in stock markets and it is our expectation that they will be rewarded in the future as well.