Previously we have discussed risk as it relates to investments on a stand-alone basis, how correlation is the key driver of portfolio risk, various alternative asset classes and historical risk and return profiles calculated through using various combinations of indices over various periods of time. In this article we?ll discuss why we (and some of the top investors and economists of all time) don't foresee equity returns over the next 7 to 10 years being comparable to those experienced over the last 20 or so years, and what that means for you as an investor.
According to the St. Louis Federal Reserve Database, during 1980-2003 period the S&P 500 Index grew by 12.93% annually (past performance does not guarantee future results; figure includes reinvested dividends and excludes tax effects), but can it sustain that type of growth moving forward? If not, what type of growth should we then expect? These questions have major implications for not only the soon to retire, but even for those with 20-30 year investment horizons. The answer is not simple and not easily explained, but if you listen to some of the top experts of our time (and of all time) you?ll come to realize that not everyone paints as rosy a picture for the U.S. stock market as the "talking heads" on MSNBC. Some of the experts we reference below include (1) Stephen Roach, (2) John Montier, (3) John Hussman, (4) Bill Gross and (5) Warren Buffett. These experts? thoughts are mixed with some of our own, so read on!
Stephen Roach, Chief Economist at Morgan Stanley (very well known and respected in institutional circles) stated in his March 12, 2004 commentary that "Today, I am more worried about inflation. But it's inflation with an important twist - not the CPI-based inflation of product markets but the asset inflation of financial markets. I fear that America's post-bubble recovery is in serious danger of spawning a new round of asset bubbles that could well pose the most deflationary risks of all." Later in the article he states, "I continue to believe that the mounting froth in both property and fixed-income markets is largely traceable to the Fed's extraordinary policy stimulus. Low interest rates continue to fuel the excess demand and price behavior in the housing sector. Moreover, with the US central bank anchoring the short end of the yield curve at 1%, commercial banks, institutional investors, and speculators are all rushing to take advantage of what could well be the "mother of all carry trades." There's no secret that this is the biggest and probably the most levered bet in financial markets today. The risk of multiple asset bubbles can only intensify as the Fed clings to its stance of extraordinary accommodation in the face of a rapidly growing and still inflationless US economy. With excess liquidity creation not being absorbed by the real economy, it is now slopping over into an increasingly broad array of asset markets. That's what bubbles are all about."
In John Mauldin's March 12, 2004 weekly e-letter he offers some recent thoughts from James Montier, the global equity strategist for Dresdner Kleinwort. Montier writes in his weekly letter that he has weighed the values of the U.S. stock market in his scale and finds them wanting. "All of our favored measures of absolute valuation attempt to abstract from the vagaries of the business cycle. Regardless of which one we examine, we reach the inescapable conclusion that the US market is vastly overvalued. For instance, the Hussman P/E (prices relative to peak cycle earnings) is currently trading on 21 times, against an historical average of 11.7 times!" (John Hussman is another well known economist and money manager.) "Even on the basis of the la-la land forward earnings multiples, the US market looks dear. The current 12 month forward P/E based on consensus earnings is just over 18 times. Inside we show that a rough approximation for the long run average forward PE would be close to 11-12 times."
Of course, some bulls would say that today's low interest rates justify high P/E valuations. That argument does have some logic, but only on the surface. If interest rates are low, then investors should be willing to take lower earnings yields from stocks, which justify higher valuations. Makes sense, right? Consider this, if rates rise, then that may be a drag on future valuation levels. It is precisely this lowering of valuation levels which may create a secular bear market.
Montier continues, "Your best chance of multiple expansion is when rates are high not low. When interest rates are low, the evidence suggests a risk of multiple contraction or stagnation. Low interest rates may explain why we have arrived at high PEs (because investors suffer money illusion), but they say nothing about the sustainability of that PE."
Montier also quotes Cliff Assness who in a Fall 2003 study for the Fall 2003 Journal of Portfolio Management divides the market into five periods of interest rate environments, from low to high. More precisely, he examined different interest rate periods over the 1965-2001 period by putting each month into one of five buckets (20% in each bucket) based on end of the month 10 year Treasury Yield. Thus, bucket number one contained the 89 months when interest rates were at their lowest over the period and bucket #5 the 89 months when interest rates were at their highest over the given period. He then looked at the average annualized 10 year real return of the S&P 500 for the decades ending in the month in question and the decade following each month in question. What he found was that the average annual real return on the S&P 500 was 10.3% for decades ending in any month when interest rates were in the bottom fifth but only 2.0% for decades ending in any month when interest rates were in the top fifth.
Although that tells us quite a bit, what is even more telling are the results in the average decade following each interest rate environment (i.e. buckets #1-5). According to Assness, he found that "The best results actually occurred in the decades starting with high interest rates, and, conversely, buying when rates were lowest actually led on average to negative real returns in the next decade." This leads to Montier's conclusion that "...the fallacy of low rates being good for equities is clearly exposed."
To sum, the conclusion was that the best time to have invested was when rates were high and the worst time was when rates were low. This is one reason to believe that we are in a long term secular bear market. Please keep in mind that past performance does not assure future results. There is no assurance these trends will continue. The study is a hypothetical example for illustrative purposes only. It does not reflect the actual performance of any security. It does not include transaction costs and tax considerations. Investments involve risk and may result in a profit or a loss. The S&P 500 is an unmanaged index of 500 widely held stocks. An investor cannot invest directly in an index.
Bill Gross, Managing Director of Pacific Investment Management Company LLC ("PIMCO") points out in his February 2004 Investment Outlook titled "The Last Vigilante" that in his opinion the most critical reformation in the past 20 years has been the transition of the U.S. from a manufacturing/to a service/to a finance-based economy within the span of two decades. He says that "...the critical difference between then and now is that profits and employment - two thirds of the critical constituents that a Fed Vigilante must protect (inflation being the third) - are now primarily a function of the amount of debt/leverage and its cost. Because this is so, we currently reside in a finance-based economy." Gross continues "Instead of buying a home with a 30-year fixed mortgage and watching one's equity grow via monthly amortization of principal, we refi twice annually, do it with variable or even interest-only loans and then spend any equity we have accumulated via "take-outs."
Gross tells us that "Because in a finance-based economy that depends on more and more low cost money in order to thrive, the game ends when either the "more and more" or the "low cost" modifiers are replaced with "less" or "higher cost." What does he mean? Well, debt as a percentage of GDP has increased dramatically over the past 20 years and is now at historically high levels approached only briefly during the depression of the 1930s (currently the U.S. Credit Market Debt/GDP ratio is 2.99x while it peaked at 2.70x during the early 1930's). Gross continues "...what seems obvious to me is that if debt stops growing at the same rate...then our economy will slow down, stagnate or worse. Who could argue that if debt as a percentage of GDP were still at 1980s levels as shown in the chart, that our consumption of things, our purchases of homes, our investment in technology, or our current government deficits would not be much smaller and our economic growth much lower. We are hooked on debt; we are a finance-based economy."
Gross contends that falling interest rates in a finance-based economy is the same thing as increased productivity in a manufacturing-based economy. Gross's point is that consumer consumption has, to a large extent, been driven by falling interest rates and increasing debt levels, and when rates begin to rise, as they always do, borrowers will pay more in real terms, affecting consumption, home building and buying, business investing, and government deficits alike. Gross finishes, "Believers in past Keynesian successes and promises of future helicopter droppings" (i.e. monetary and fiscal stimulus, or lowering of Fed Funds Rate and tax cuts) "are confident it can be done"that our U.S. and global economy can ultimately exhibit stable long-term growth rates with the government's wind at its back. I have my doubts. Keynes, like Volcker, conjured his magic in a simpler manufacturing/agricultural-based world. In a finance-based economy it is the growth in leverage as well as its costs that call the shots." "...a lender, who lends money not as a participant in some money management game or contest, but with the expectation of getting his or her money back in inflation-adjusted terms and then some, will demand that the growth of leverage cease and/or that its cost increase to reflect the increased risk. Either demand will force this economy to retreat."
Warren Buffett in his 2003 Berkshire Hathaway Chairman's Letter released March 8, 2004 says, "Yesterday's weeds are today being priced as flowers...We've found it hard to find significantly undervalued stocks...The shortage of attractively-priced stocks in which we can put large sums doesn't bother us...Our capital is underutilized now, but that will happen periodically. It's a painful condition to be in, but not as painful as doing something stupid. (I speak from experience)...I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I." Further, in an October 27th edition of Barron's, the billionaire investor and chief executive of Berkshire Hathaway said that he was not impressed with the current opportunities in stocks, Treasury bonds or junk debt. "We've got more cash than ideas. The question is whether that will prevail for an unduly long time." In fact, Berkshire sold $9 billion of long-term Treasury bonds this year, and Buffett said buying stocks at current levels is not a wise move, according to the report.
So what does all this mean for you? It's not that we are trying to scare, only get you to think and to protect yourself and your savings. Are we advocating that you exit the U.S. equity markets? Most definitely not! What we are advocating is that over the next decade you practice true asset allocation. Again, we are not saying that you should pull all of your long-term investments out of the U.S. stock market, but you may need to trim your exposure. We do not practice short-term market timing and do not advocate this to others. However, longer-term trends may be foreseeable; and there is no point in taking additional risk to achieve a lower return! We do believe in the U.S. stock market and the U.S. economy in the long-run, but remember the two are not always correlated (see the late 1990's). A painful lesson will most likely, at some point, be learned; the S&P 500 Index does not always provide the 13% returns (12.93% over the 1980-2003 time-period including reinvested dividends and excluding taxes; Source: St. Louis Federal Reserve Database) to which we have all become accustomed. Remember too that we have not gone into full detail here as to how you can truly diversify. We have not detailed developed or emerging markets debt and equity instruments, treasury-inflation protected securities (a type of bond) or various hedge fund structures (such as convertible arbitrage, long-short equity, etc.) as we are trying to keep this series somewhat basic. These are, however, more diversification tools that some of you may have at your disposal.
Play it smart and don't take unnecessary risks. Learn how to build a truly diversified portfolio and plan your required return around future cash flow needs. You don't have to ride the U.S. stock market roller coaster; besides, we may be seeing a lot more downs than ups over the next decade. Why take that chance if you don't have to?