This morning I received a blog written by Brad DeLong which asked a simple question; why are people depressed about medium-term prospects for equity investments? He claims he doesn’t understand the gloomy mindset. However, the evidence contradicts DeLong’s underlying assumption about investor attitudes. And when we dig deeper, we find that history doesn’t support his assumption about future market returns.
The title of his post suggests that MANY individuals are depressed about future equity returns which would suggest that investors are bearish and are hoarding cash. However, this is hardly the case when the majority of investors are fully invested and leveraged as shown in the two charts below.
 
 
There are only a few people, besides myself, that discuss the probabilities of lower returns over the next decade. Â Henry Blodget, the focus of the DeLong’s post, Jeremy Grantham, Doug Short, Crestmont Research and John Hussman are the most notable.
 Let’s jump into Brad’s math.  He states:
“I see that stocks are likely to return:
- 6%/year in real (inflation adjusted) terms,
- plus or minus whatever changes we see in valuation ratios.
That means that if we expect to see P/E10 fall over the next decade from 25X to 19X then we can expect to see returns of 3%/year real–that is, 5%/year nominal. That means that if we expect to see P/E10 fall all the way back to 15X over the next decade, then we can expect to see returns of 1%/year real–that is 3%/year nominal. But that is unlikely to happen. And if P/E10 remains at its current valuation ratios, we have 6%/year real returns–8%/year nominal.
Equities still look very attractive to me…”
First, he makes the assumption that stocks will compound at 6% per year, every year, going forward. Â This is a common mistake that is made in return analysis. Equities do not compound at a stagnant rate of growth but rather experience a rather high degree of volatility over time.
