Valuation Drives Decadal Returns -- Beware Investor Extrapolation Bias

Key Quotes

"The real trouble with this world of ours is not that it's an unreasonable world nor even that it is a reasonable one nor even that it is a reasonable one the commonest kind of trouble is that it is nearly reasonable but not quite life is not an illogicality yet it is a trap for logicians it looks just a little more mathematical and regular than it is its exactitude is obvious but its inexactitude is hidden its wildness lies in wait"

Antti Ilmanen includes this quote to emphasize the need for humility in forecasting market expectations. He suggests that the world, and by extension financial markets, are not perfectly logical or predictable, making precise predictions a difficult and potentially misleading endeavor. This highlights the inherent uncertainty in investment forecasting.

"so first objective expected returns they are pretty much what i've been talking about in my writing what people talk when they they talk about capital market assumptions largely it's basically the kind of expected returns that are reasonable to have from a rational perspective they could be something that has got the ability to predict future returns market yields do tend to do that even if they sometimes fail miserably and we've seen quite a bit of that in the last last 15 years but the basic idea with objective expected returns is that if you have got high starting years which means low valuations then that predicts higher long run returns and subjective expectations can behave in almost the opposite way they extrapolate past decade growth for example or returns and that's why we call it sort of rearview mirror mindset with the with those subjective expected returns"

Antti Ilmanen distinguishes between objective and subjective expectations for investment returns. He explains that objective expectations are based on rational, forward-looking measures like market yields and valuations, suggesting higher returns when valuations are low. In contrast, subjective expectations, which he terms the "rearview mirror mindset," extrapolate past performance and growth, potentially leading investors astray.

"so what we do early in the early in this series is to contrast the yield based estimate such as inverse of cape ratio predicting future returns and it's kept point five correlation or something like that so it's pretty decent looking at longer horizons but it also sucked quite a bit and we'll return to that but it sucked in the last decade especially for us but it's still if you look at the long run data it's better to have point five positive correlation than what we see if you look at the rearview mirror where it's minus point three correlation looking at last decade's returns versus next decade returns so there is medium term mean reversion there in returns and rearview mirror is really poison if that keeps happening"

Ilmanen presents evidence that yield-based estimates, like the inverse of the CAPE ratio, have a historically positive correlation with future returns, indicating a tendency for mean reversion over the medium term. He contrasts this with the "rearview mirror" approach, which extrapolates past returns and shows a negative correlation, suggesting it can be detrimental if that trend continues.

"the struggle for i mean i think everyone listening to this right now is most of our listeners are in the us you're in finland right now today so you got a little bit of a global perspective but i feel like a lot of people have looked at this particular bull run and when it comes to the rear view mirror of said yeah but this is the only game in town this is the way it's going to be talk to us a little bit about is this particularly a challenging point in time how do we think about these two conflicting kind of ideas"

Ilmanen addresses the challenge of investors, particularly in the US, who may be overly focused on recent strong performance and extrapolating it into the future. He frames this as a conflict between the "rearview mirror" mindset, which assumes recent trends will continue, and a more historically informed perspective that acknowledges potential shifts and mean reversion.

"the history really has been great for investors but future looks bleaker and we've been living that future for the last couple of years and i don't think it's over yet but that's that's you know i always scratch my head when i hear people start to talk about on twitter and elsewhere they're like yeah but the fed's cutting rates all the risk assets are going to go to the moon and i was like but you guys remember the last three times the fed cut rates you know big like and big time i mean multiple percentage points some of those stocks risk assets didn't do great in those sounds like what are you guys talking about they two of those times they went down 50 and one of them they went down 20 i'm like that's a dangerous assumption to make that just because the fed's going down that you know things are going to look good"

Ilmanen expresses caution regarding the future prospects of private equity, suggesting that while past returns have been strong, the outlook is less optimistic. He critiques the assumption that falling interest rates automatically lead to positive outcomes for risk assets, citing historical instances where significant rate cuts were followed by substantial market declines.

"so the the main message is in some way from the rearview mirror is that the rearview mirror looks much too benign for overall market especially for us and maybe tech but tech you know the ai story is of course that if i'm wrong on this then it's because of ai and on liquid versus illiquid alternatives i do think that it's it's this is basically the environment now i think is is better for the for the true diversifiers and even you know equity premium looking at stocks versus bonds from starting yields in us it is it is quite thin it is not zero but it is it is thin so i'd be yeah i'd be cautious on risky assets more so probably on illiquids but they also know i'm i'm humble enough to know that any of these forecasts can be wrong and we really we many of us know the story of greenspan's irrational exuberance in december 96 and then markets rallying another three plus years so cautious on the time but but i'm definitely leaning towards caution here with with all of this"

Ilmanen summarizes his main message as a caution against the "rearview mirror" perspective, which he believes is too optimistic for overall markets, particularly US equities and tech. He suggests that the current environment favors true diversifiers over risky assets, especially illiquid alternatives, while acknowledging the inherent uncertainty in any forecast.