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What if the lesson of history is that the future will be unlike the past? In that event, of course, all bets are off. Yet this distinct possibility comes from several different historians of U.S. financial markets. Each of them points out that the financial markets periodically undergo profound sea changes, after which they bear little similarity with what came before.
This means that the study of history tells us little other than that the future is unknowable.
Bryan Taylor, chief economist at Global Financial Data, believes the U.S. markets currently are undergoing another of these sea changes. In an interview, Taylor said he expects a coming era of persistently low interest rates.
It would be unrealistic to expect anything like the declining interest rate era from 1982, he added, since interest rates are already so low. While an era of rising interest rates is possible, as was the case from 1945 to 1981, that also seems unlikely in light of the Federal Reserve’s stated intentions. The chaotic markets of the 1914-1945 period that included two world wars also seem an unlikely guide for the future, as does the 1792-1914 period during which the U.S. underwent a transformation from an agrarian to an industrialized economy.
This is why Taylor believes we’re entering uncharted territory. He said that his best guess is that the equity premium going forward will be small — around 3%. If so, U.S. stocks in this era that is dawning will produce returns that are, at best, mediocre.
Recall that bonds’ long-term returns are highly correlated with their beginning yields. The 10-year U.S. Treasury
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currently yields around 1.64% in nominal terms, and minus 0.78% after inflation (assuming inflation equals the current 10-year breakeven inflation rate). An equity premium of 3% therefore translates to an expected stock market return of just 4.64% annualized before inflation, and 2.22% annualized after inflation.
The challenge for financial historians
Taylor stresses that his 3% equity premium estimate “is only a dart-throwing guess.” That perhaps is the more important point of this discussion: No one is able to do anything better than guessing.
Even more importantly, furthermore, notice that our guesses don’t become any more accurate by studying more and more history. If we base our forecasts on what’s happened over the last four decades, we’d project an equity premium of 1.33 annualized percentage points. We can torture the data to project a higher equity premium if we extend our analysis back to World War II, or a much lower premium if extend it even further back to 1792.
This perspective challenges us to approach financial market history in an entirely new way. We typically view the financial markets the way political pollsters approach their jobs, as they believe that their projections of election outcomes will be more reliable to the extent they sample a greater number of voters.
But if the financial markets are instead a progression of profoundly different eras that bear little resemblance to each other, then analyzing more history doesn’t necessarily produce more insight.
The bottom line? Humility is a virtue. Those who project confidence because of how much history they’ve included in their models are like those who are often wrong but never in doubt.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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