In May of 2009 Mohamed El-Erian presented PIMCO's concept of a "New Normal" to the general public.
Coming so soon after the financial crises of late 2008 and early 2009, the concept understandably became the subject of debate, but by August, 2010 it was beginning to gain wider acceptance as a possible roadmap for navigating markets in the future.
If true, the New Normal has significant implications for retirees that are planning on living off of the proceeds of their IRAs. This is because it addresses the outlook for both growth and volatility, the two key ingredients of investment portfolio management.
In this article I'll address my views on the salient New Normal characteristics and try to examine if, as we approach its 3-year anniversary, the New Normal should be factored into retirement planning.
In various PIMCO references to the New Normal since the original May, 2009, white paper they have suggested that it is characterized primarily by:
- Global economic activity that will be muted, with lackluster growth in developed markets, and with emerging market growth reduced to "pre-New Normal" developed market levels.
- Increased uncertainty (reflected in market volatility) as regional economies engage in "Multi-Speed" recoveries as they struggle with internal monetary and fiscal issues.
Can we quantify these characteristics to both a) validate (or invalidate) the New Normal, and b) project the implications going forward?
Global Economic Activity
One of the most convenient and freely-available sources of global economic data is the interactive IMF Data Mapper(r).
Selecting the two regions of interest (advanced economies and emerging economies) one can view historic GDP trends as well as IMF's forecasts for the next five years:
A quick visual scan of the GDP trend of the advanced economies (blue line) seems to support the PIMCO view of muted growth; annual GDP growth since 2008 so far has been well below the 3-5% annual levels prior to 2008. (And with IMF forecasts in the range of 1.9 - 2.7% through 2016 it might appear that they believe in the New Normal as well).
However, the GDP trend for emerging economies hasn't (at least up to now) seemed to support the PIMCO view. Despite actual and predicted levels that are below the high levels seen in 2004 - 2007, at no point does the tan colored line after 2008 come close to the highest points of the blue line.
Strictly speaking, of course, this is an analysis of macroeconomic activity as measured by GDP. To translate this into an outlook for market returns (which are of more practical interest to retirees), I am guided more often than not by Warren Buffett's prescient view of the markets from the November 22, 1999, issue of Fortune Magazine:
"So I come back to my postulation of 5% growth in GDP and remind you that it is a limiting factor in the returns you're going to get: You cannot expect to forever realize a 12% annual increase--much less 22%--in the valuation of American business if its profitability is growing only at 5%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do."
In other words, I assume that the trend in real corporate earnings will, over the long run, revert to the trend in real GDP growth ... Especially in the case of broad-based index ETFs such as SPY.
What I see now would suggest to me that an investor seeking "pre-New Normal" returns going forward should consider a somewhat higher portfolio allocation into emerging markets (such as, for example, EEM).
Of course, such a shift in allocation would be expected to increase the volatility of the portfolio (something the retiree does not want to have happen).
So this brings us to an examination of the second aspect of the New Normal:
Increased Uncertainty (Market Volatility)
Rather than revisit a previous article that discussed the difficulty in selecting the "correct" volatility (i.e., uncertainty) measure, let's simplify things and look at how the VIX ("fear index") has been trending since PIMCO introduced the New Normal.
The chart below shows the history of the VIX from January, 1990, through the present (well, actually, February 22 of 2012; it took me a while to get around to writing this article after accumulating the data I needed).
Up to September, 2008 (the beginning of the financial crisis) the VIX average was about 19, as indicated by the lower horizontal dotted line.
After September, 2008, the average has been about 28 and is illustrated by the upper horizontal dotted line. Granted, the recent trend since the beginning of this year has been downward, with the current level hovering near 15. But I think it's a bit premature to say that this suggests we're in for a sustained period of continuing low volatility.
The point is that, at least by this measure, the data seems to have confirmed PIMCO's prediction back in 2009 of higher volatility over a 3-5 year time horizon.
An efficiency approach based on Sharpe Ratio
An alternative means of assessing the New Normal is by tracking the ratio of return to volatility. That is, if returns have been decreasing and volatility has been increasing, then the ratio of the two should show a definite downward trend.
Some may recognize this ratio of return/risk to be the Sharpe Ratio (for the special case of risk free interest rate = 0). Suffice it to say that the ratio, expressed in this manner, is an indicator of the return one is receiving for each unit of risk. If the Sharpe Ratio of an investment is declining, then one is experiencing more volatility relative to the return one is receiving.
The chart below shows the mean monthly price return of the SPY ETF divided by the standard deviation (volatility) for all rolling 12-month periods since June of 1997.
The data is noisy, to be sure. But the current value (0.07) compared to the average of values in the 5 years prior to September, 2008, (~0.4) suggests a reduction in the return/risk ratio.
Moreover, the best fit linear trendline (shown in red) across the entire time period since 1997 suggests this as well.
So what is the takeaway here? Without assigning too much in the way of thoroughness and accuracy of this analysis, I have at least satisfied myself that the PIMCO New Normal is worth considering in my current investment approach.
And in Part 2 of this series, I hope to demonstrate that an extended time period under which New Normal conditions might prevail could have a dramatic impact on portfolio drawdown rates for retirees.
I hope you will continue to follow the series.
Disclosure: I am long SPY. I hold both long and short option positions in SPY.