Bridgewater Associates: The Next Decade - January 2000

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17,U.S. code). 1 Bridgewater ® Daily Observations 1/05/2000 Bridgewater Daily Observations January 5, 2000 © Bridgewater Associates (203) 226-3030 Ray Dalio Claude Amadeo Vivin Oberoi United States The Next Decade Revised 3/10/2006 As mentioned in yesterday’s Observations, I will show you a batch of charts that will help to put where we are today into perspective. They’re not the sort that one would look at to gauge what the next several months or one year will look like, but they are the sort that should be seen if one is thinking about the next decade. To be clear, my comments that accompany these charts are just observations that come to mind when I look at them – they aren’t forecasts. The first chart is of real GDP through this century. As shown. real growth rates haven’t changed much – i.e., there are no big bows or shifts in the slope. It averaged 3.2% and, except for the dip in the early 30’s and rebound extending through the war years, it didn’t vary much from this – the standard deviation across decades was 1.3% (mostly because of that dip and rebound). Post- 1950 numbers were similar. Since 1950 real growth averaged 3.6% with standard deviations across decades of only 0.6%. Said differently, to the extent that real GDP reflects living standards, they have risen at a pretty steady state all along, rather than in spurts and sputters. The inventions, and productivity shifts arising from them, came along in a relatively continuous way. For the most part, inventions seem exceptional to us at the time because of their newness, not because of how exceptional they really are. Will the effects of the internet be greater than those of electricity, will cellular communications’ impact be greater than that of the telephone? When averaged in with all else that is going on, will these new technologies shift this line in a way that is different than it has trended in the past 100 years? I doubt it. If you are inclined to believe that the past has been more indicative than misleading (which I am), you might guess that the next decade’s real growth rate will be around 3 ¼% to 3 ¾%, give or take about 1%. Extreme optimists might assume about 4 ½% growth (i.e. the highs) and extreme pessimists might assume something close to 0% (which would be a depression scenario).
  • 2. Real GDP ($1987) 100 1000 10000 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 4.7% 2.3% 3.4% 0.1% 4.3% 3.9% 4.5% 3.3% 3.0% 3.0% The next chart shows real earnings going back to 1900. They increased at an average of 1.7% with a standard deviation of 3.9. Earnings are more volatile than real GDP for lots of reasons that make sense and I won’t bore you with. Not surprisingly, their growth rate was highly correlated (72%) with real GDP’s. It was also strongly mean reverting – i.e, the faster real earnings growth was in one decade, the more likely it was to be slower in the next. In fact, we regressed the next decades’ real earnings growth rate as a function of the previous decade’s growth rate, and found the results to be GrowthT+1 = .03 + -.85 GrowthT with an r2 of .70. At its extreme, real earnings growth rate for the S&P was 5.1% in the 1940’s as a bounce back from the –5.1% growth rate in the 1930’s. One who believes that the next decade is more likely to be a variation on the past than a whole new beast would probably assume that real earnings growth will be in the 2% vicinity, give or take 2%. If you applied the simple regression formula, you would assume a – 0.6% real earnings growth for this decade. In any case, you would not assume that real earnings growth would be blistering. Real Per Share Earnings Growth 1 10 100 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 6.8% -5.1% 5.1% 0.3% 3.3% 2.3% 0.5% 4.2% -4.7% 3.5% In light of this, it is interesting to see how future growth is being discounted by the markets. The next chart is of the S&P P/E . It is high. How high? Let’s assume that the past century’s circumstances are relevant and that we are not in a whole new era. We will play with the 2 Bridgewater ® Daily Observations 1/05/2000
  • 3. numbers a few ways. If one assumes that the real earnings continued on trend and the S&P P/E ratio reverts to its long-term average over the coming decade, then the price change on the S&P would be –7%/year. With a current dividend yield of about 1.2%, this equates to a roughly –5.8% total return. If P/Es revert to their long term average, to get the total return to be 0%, we would need real earnings growth to be 7.7% a year. As noted in looking at the last chart, that is well above the long term average trend real growth rate of 1.31% and has never occurred. The real yield on 10-year inflation indexed bonds yield is 4.3%, so that is a more reasonable minimum acceptable return than our assumption of 0%. To meet this return requirement under the assumption that P/Es return to normal, real earnings would have to grow 12.3% a year, or 11% above the long term average real growth rate and nearly double the fastest growth rate for any prior decade. S&P P/E Ratio 5 10 15 20 25 30 35 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 The next chart shows the Dow and S&P in real terms going back to 1900. There are upward slopes in these lines (reflecting real earnings growth and changing risk premiums) that are about 1.65% a year in both markets. Moreover, there are meaningful variations around these upward tilts. In other words, when real prices are above the trend, there has been a tendency for real prices to fall, and visa versa. Currently, real S&P and Dow prices are at new highs and above their long term averages by 120% and 104% respectively. If one simply estimated the next decade’s real return as a function of it’s level relative to trend at the beginning of the decade, one would project the S&P real return to be -10%/yr., and the Dow’s real return to be -8.8%/yr. over the next year. 3 Bridgewater ® Daily Observations 1/05/2000
  • 4. Dow Jones Industrial Avg in Real Terms (ln) and the S&P 500 in Real Terms (ln) 3 4 5 6 7 8 9 10 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 DJIA S&P 500 The next chart shows BAA bond yields divided by S&P E/P ratio. People say that 6 ½% bond yields aren’t attractive, but they have never looked so good next to earnings yields. Where will this ratio be at the end of the next decade? As I said earlier, I’m not forecasting, I’m just observing. The higher bond yields are relative to stock yields, the faster earnings growth must be (assuming steady risk premiums). So, if the earlier observations about GDP and earning growth rates were reasonable, it is also reasonable to assume that this ratio will be lower, not higher a decade from now. That decline could occur though either a lower stock price, a lower bond yield, or both. Baa Bond Yield Divided by The S&P Earnings to Price Ratio 0.0 0.5 1.0 1.5 2.0 2.5 3.0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 4 Bridgewater ® Daily Observations 1/05/2000
  • 5. The next chart shows Baa and T-bond yields. While they are low relative to where they were in the ‘70s and 80’s, they are still high in relation to all other times. Baa Corporate Bond and Treasury Bond Yields 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Baa T-Bond The next charts shows a proxy for these real yields in the form of nominal bond yields minus a 3 year moving average of inflation. They are 4 1/2% to 5 1/2%. Inflation-indexed bond yields can be locked in at 4.3%. Prior to the 1980’s, such high real yields never existed except in deflationary depressions. Baa Corporate Bond and Treasury Bond Yields Relative to Past 3 Year Inflation Average -15% -10% -5% 0% 5% 10% 15% 20% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Baa T-Bond 5 Bridgewater ® Daily Observations 1/05/2000
  • 6. The next chart shows the Debt/GDP ratio of the U.S. We show both the ratios based on both the total debt and the non-financial debt. By either measure, the economy is very leveraged- the most since the Great Depression. Total Debt Divided by GDP 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Total Non-Financial Great Depression (GDP fell faster than Debt) (Debt increased faster than GDP) The next chart shows net interest as a percent of GDP, which is a better reflection of the debt service burdens. It is down while the Debt/GDP ratios are up primarily because interest rates have come down. As interest rates fall, debt service burdens are reduced, all else being equal. Of course, this is a sword that cuts both ways. As interest rates rise, given the high debt/GDP ratio, debt service burdens would rise at an exceptionally fast pace. Similarly, if GDP fell and everything else stayed the same, debt service burdens would rise. Debts are never problems when money is easy and growth is strong -- they do not trigger recessions. Rather, the classic relationship is that tighter money and economic weakness make the burden greater – e.g., the high debts were not a problem in the U.S. in the 20’s or Japan in the 80’s but they were big problems in the 30’s and the 90’s, even though they didn’t increase. In 1929 and 1989, the central banks in these countries increased the debt burdens by tightening, this caused GDP to fall and these debt burdens depressed these economies for the entire next decade. So, one should not take comfort in noting that debt levels are not particularly high in relation to earnings levels, particularly if there is an increasing risk of central bank tightening. Net Interest as a Percentage of GDP 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 193 1982 1989 6 Bridgewater ® Daily Observations 1/05/2000 I’ll just show you a few more interesting charts and let you get on with other things.
  • 7. The next chart shows Baa corporate spreads divided by the T-bond yield. One isn’t being paid much to take credit risk. Baa Corporate Bond Yield Divided by Treasury Bond Yield 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 The next chart shows our trade balance as a percent of GDP. As noted before, our trade deficit is large because foreign investors have been keen to invest in our markets and we have used this money to fuel our excess consumption so that the current account deficit would roughly match the capital account surplus. Where will that be in the next decade and what will the dollar have to do to get it there? Balance of Merchandise Trade as Percentage of GDP -4% -2% 0% 2% 4% 6% 8% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 7 Bridgewater ® Daily Observations 1/05/2000
  • 8. The next chart shows the Federal budget balance as a percent of GDP and the cyclically adjusted deficit. Budget Deficit % GDP -40% -35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Federal Budget Deficit Cyclically Adjusted War Years War Years 8 Bridgewater ® Daily Observations 1/05/2000
  • 9. Overview: So, the real question is, is the past prologue or are we in a whole new ball game? That’s a cosmic question which each person must answer for himself. As mentioned yesterday, I am doubtful that the next decade will be characterized by the exceptionally fast GDP and earnings growth rates that are being widely assumed, and I do not believe that stocks will be a good investment. I do believe that a 4.3% real yield for US Treasury I/I bonds is a great deal. I think the economic risks are more on the downside because of the economy’s indebtedness and external deficits, and I think volatility will almost certainly pick up. I also remember the saying that “he who lives by the crystal ball is destined to eat ground glass”. BOJ Intervention: Overnight, as the yen hovered near its highs against the dollar, the BOJ intervened, selling an estimated $2-3 billion worth of yen in an effort to forestall a rise in the yen. The last intervention by the BOJ was back on December 24th and that one occurred at similar levels (~101.5). The following chart shows the interventions conducted by the BOJ over the last year (vs the dollar) in relation to the movement in the spot exchange rate. Tuesday’s intervention size is small in relation to some that occurred last year, but the same size as the BOJ has recently been intervening with. Spot Yen/Dollar vs Estimated BOJ Interventions (bln US$ worth of yen sales) 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 12/31/98 2/19/99 4/12/99 6/1/99 7/21/99 9/9/99 10/29/99 12/20/99 100 105 110 115 120 125 Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it do not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues. 9 Bridgewater ® Daily Observations 1/05/2000