“It’s time to reset your investment assumptions”..says the Globe and Mail. But is it, and should it be up or down?

Is it really time to reset your return assumptions downwards? A Rob Carrick articlein the Globe and Mail suggested that it might be so.

Revising return assumptions down after poor stock market returns is a Bete Noire of the financial services industry.  All other things being equal, and depending on your paradigm, you should be revising them up after a period of poor returns.

But you cannot revise upwards if your return assumptions were too high to start with. If you have relied on historical average returns or risk premiums to set return expectations you have also more than likely failed to adjust for cyclical and structural risks in markets and economies.

The lower the market valuation, the higher the nominal GDP growth rate, and the less advanced the economic cycle, the higher the nominal expected return is likely to be. The more advanced the economic cycle, the more extended the valuation and the lower the nominal GDP growth rate, the lower the nominal expected return is likely to be.

Additionally, the higher the total debt, the lower the real per capita income growth, the lower the savings rate, the smaller the population growth, the larger the capital stock, the smaller the total factor productivity, amongst other factors, the lower the expected returns, and vice versa.

In other words as markets moved up to their cyclical and valuation extremes towards the end of the 1990s (and for Canada the period prior to the onset of the most recent crisis), the industry should have been lowering its return expectations, they should have been increasing them in the ensuing bear market, reducing them up to 2007, increasing them as markets fell through 2008 and 2009, reducing them as they recovered, and recently, increasing them as they fell again.

In the absence of significant structural economic imbalances, returns predictably vary with market valuations and economic cycles.

But, once you start to build in outsized systematic structural economic risks (high to extreme debt levels, excess consumption relative to GDP/excess fixed capital investment relative to GDP etc.), historical return patterns and forward looking return expectations start to disassociate.

This is the first of a set of posts that look to explore factors impacting equity risk premiums and expected returns in the new normal.

Those who believe in MPT, general equilibrium theory and efficient markets would suggest that growth rates are not path dependent and hence periods of poor returns/strong returns should not result in any adjustment to return expectations.  While there is indeed uncertainty over many components of return, we do not live in a pure probability realm with a constant mean and a known population distribution of return.

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