I’ll save you some time – skip the first four pages. Uncharacteristically, Marks spends a majority of his letter fixated on a grammatical misrepresentation of an essoteric topic. Equity Risk Premia is an important consideration for investing for sure. Author and practitioner, Antti Ilmanen, does a fine job in defining and cataloging it in his book, Expected Returns. However, Marks belaboring the issue on its mundane use by P&I is not particularly enjoyable.
On the other hand, his insights on today’s equity market are interesting. Marks earned his stripes as a distressed bond investor, and as such, usually provides a unique insight on equity markets. His review of earnings yield over different historical points and comparison to that of today is a nice educational tidbit.
To gauge relative price-attractiveness, it isn’t unreasonable to compare the earnings yield on a stock against the yield on a bond (or against the risk-free rate)… [In the post WWII period], the ratio between the yields was 6.25%/3.00%, or 2.08x. At the high in 2000…the yield differential or equity risk premium was a skimpy 1.12%…. [Today, we have] a yield differential of 5.25% (6.25% minus 1.00%), or 525 basis points, and a yield ratio of 6.25%/1.00%, or 6.25x.
To quote Yale Professor Robert Shiller, “we have a tendency to dogmatize and oversimplify. But the world is not simple; it cannot be reduced to a simple framework.” Marks completely recognizes this in spades.
“The problem with basing a pro-equities argument on the yield comparison is that most of equities’ current attraction on that basis comes from the lowness of interest rates. Just about everyone knows (a) interest rates are artificially low because of central banks’ efforts at stimulus and (b) rates will be considerably higher at some point in the intermediate term. In that case, rising rates would render stocks less attractive (all other things being equal, but they’re not)”
He tackles a number of Pros and Cons that face the equity markets, and makes certain conclusions.
So now we have a somewhat improved fundamental environment, a generally more optimistic group of investors, and stock prices that are a fair bit higher. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I’d say we’re somewhere in the first half of stage two. Pessimists no longer control market prices, but certainly neither have carefree optimists taken over… I’m quite comfortable imagining a few years of equity performance that provide a pleasant surprise relative to what I think is the prevailing expectation of 6% or so per year. [his emphasis]
He ends with a theme that we have discussed here to great extent. He knows not for sure that equities will perform in-line with his predictions. However, he is unlikely to feel regret that he missed any major move in bonds. With 10-year Treasury rates near 2%, there is little to “miss.” Investing is about risk/reward. Predictions rest on probabilities, and the probability of great near-term returns in bonds is quite low.