The Future of Investing

A reader who works in the industry emailed me over the weekend and commented that he believes "the future for investing will be much different than the past."

I generally follow that line of thinking. I have been writing about the evolution of investing from the start of this site, exploring the merits (or lack thereof) of new types of asset classes, and have implemented a couple of these types of investments in client accounts.

That the investment world is changing is something I can buy into, but it is difficult for me to wrap my head around the idea that a bell rang in late 2007 marking the end of equity investing as we know it. My expectation was that over a longer period of time equities would become less compelling for an extended period, consistent with my past comments about equities averaging closer to 5% over time, not 10%. Further, I would have expected such a transition to be much quieter than the fast 50% decline for the broader averages.

Reading that a shift away from equities should theoretically be slower and quieter, you might reply that the shift is not over the last 15 months but the last ten years. That might be correct, of course, but cutting in half as we did from 2000-2002 was not unprecedented. The market does that every few decades but never twice in a decade (that I am aware of).

While the second 50% decline this decade works against my thesis, I had one thought that supports equities not being dead. As the current bear market started in 2007 market participants had a certain knowledge of history and truisms of how markets work and many people in the market in 2007 were also in the market in 2000. Only a small fraction of market participants in 2000 knew first hand what it was like to live through a 50% decline. Today, almost all market participants know first hand what it was like to live through a 50% decline because it just happened a few years ago. Point being that if you have survived a 50% decline previously, you are less likely to be scared out when the next one comes along.

The fear created in 2002 was new for enough people that it allowed for emotion to peak and stocks to bottom. The fear created by the second 50% decline is less than the first one, which prevents emotion from peaking at the same level as before, so it prevents stocks from bottoming at the same level. Put differently, perhaps we need a lower level on SPX to create the same fear that created a bottom in November 2002.

If this is true, then it may not be the end of equities, just a larger decline to create the bottom. For what it's worth, I do not believe it is the end of equities, I believe returns will be lower than average, which is not the same as the end of them altogether.

To be clear about one thing, this post is an exploration of market psychology, not a discussion of the current fundamentals.

Comments

[.crazylegs..:]

Don't future potential returns increase as the market decreases? So perhaps if the S&P 500 were at 1400, your 5% returns going forward may make sense. However, at half that level today, perhaps future returns could be more "normal" at the 8-10% per year annualized returns going forward. It all depends on how much the massive debt creation over the last few years juiced aggregate end demand. Once we get to that market clearing level on true GDP financed by cash earnings/income and not borrowings, we could ostensibly return to historical return numbers on equities.

Mar 02 01:10 PM

[Roger Nusbaum:]

Larry, this feels like a "scare the hell out of them" moment. If so then many folks would do the kind of look in the mirror you describe. This could mean we drag this out for quite a while longer--oof I hope that is wrong.


On Mar 02 12:40 PM Larry House wrote:

> Hi Roger. A lot IS changing in investing right now, and it doesn't
> mean equities are dead forever, that is to create a false extreme.
> However, investors are getting scared to death. When you see a shark,
> it probably takes quite a bit of time and reassurance to go back
> into the water. Many investors are coming to the conclusion "I don't
> need this," especially investors who are near or in retirement.
> They are making a move away from equities that will not change.
> In the same way, many consumers are finally swearing off of debt.
> It has taken a blow to the head to make them see the light, but they
> see it now, and consumerism is not, in my opinion, going to return
> to the status quo over the next several years. I totally agree with
> the view of lower expectations for equity returns. I have been saying
> that for some time. But that very point makes equities less attractive
> when similar yields can be obtained with less risk in the bond market.
> That is another headwind for stocks to overcome.

Mar 02 01:12 PM

[H.J. Huneycutt:]

"The market does that every few decades but never twice in a decade (that I am aware of)."

Actually, it did happen twice in a 10-year period before. It basically lost half its value in the 1919-21 bear market and then, obviously the Great Depression crash began in 1929 (and the market lost half its value rather quickly in that one).

The Great Depression crash was the most rapid one in history (that I'm aware of) and it occured with the memories of the early '20s recession (and hyperinflation in Weimar Germany) fresh on peoples' minds in 1929.

Mar 02 01:17 PM

[H.J. Huneycutt:]

Actually, for that matter, two of the Great Depression crashes occurred with 10 years of one another and the Dow lost 50% or more of its value in both: the original 1929-32 bear market and then the crash of 1937.

Mar 02 01:21 PM

[MarvinMBA:]

Our whole financial system is in the process of disintegration as witnessed by the stock market and banking system. The economic model that we have used to try to predict the future is in little pieces. Uncle Sam is going to be part of the new economic model going forward. In order to find direction, try to rearrange the pieces including Uncle Sam's influence into a new model of the economy...from supply and demand to equity/commodity investments. This new model should be worldwide in nature to be accurate. It's too early to predict what this model will look like and any attempt to predict where we will be 5 years from now will be full of errors. Those now icting when and how the stock market will be in the near term or future are just shooting darts.
MarvinMBA

Mar 02 01:46 PM

[Steve in Gr...:]

Interesting post, Mr Nussbaum. A couple of thoughts:

1) The "bell" that rang in late 2007 was the realization of the likelihood of leftist control of the Federal government. An anti-capitalist Federal government is not favorable for equities.

2) I do not agree with your argument that the 2000-02 bear market made fear less likely. I think it is at least as likely that it made it more likely for investors to bail out more quickly. (I've seen this before and I'm not going through it again.) Probably both impacts more or less offset each other.

3) The bottom this time will be lower (relative to the top), because the country risk (due to the more toxic political environment, higher debt levels, etc.) is much higher than it was in 2000-02.

4) Investors take time to give up. It took 2.5 years from the top on 3/24/00 to the bottom on 10/9/02. If it takes 2.5 years for the full collapse, then we are talking second quarter 2010 (from the 10/9/07).

We are more than a year from the bottom, and we've got farther to go down from here.

Mar 02 01:50 PM

[Chris B:]

"The fear created by the second 50% decline is less than the first one, which prevents emotion from peaking at the same level as before, so it prevents stocks from bottoming at the same level. "
----------------------...

I lived through both declines and I'd say the fear is greater this time than it was in 2002. For one, the tech bust was much more gradual than the steep freefall of the last few months. Also, the baby boomers who make up the majority of investors are 7 years closer to retirement now than they were in 2002, and many still had their funds gambled - ahem, invested - in the stock market. Finally, most investors are political conservatives, which made 2002 a much more comfortable year for them than 2009.

In 2002, you just didn't hear talk about socialism being imminent, hyperinflation, a depression, or the end of capitalism as we know it. We were all waving our flags, preparing for what we thought would be a short, inexpensive war, shifting our investments towards real estate, and reducing our savings rate at the suggestion of our president.

Mar 02 01:52 PM

[ROLEXROLEX:]

the future of investing is dead.

Mar 02 02:07 PM

[boats:]

Are you refering to the speech he stumbled through while echorting Americans to do their patriot duty and head for the mall? Interesting that he'd suggest people congregate in malls after a "terrorist" attack! What does he know about the attack that he was unconcerned for his subjects, er citizens, safety? Hmmmm?


On Mar 02 01:52 PM Chris B wrote:

> "The fear created by the second 50% decline is less than the first
> one, which prevents emotion from peaking at the same level as before,
> so it prevents stocks from bottoming at the same level. "
> ----------------------...
>
> I lived through both declines and I'd say the fear is greater this
> time than it was in 2002. For one, the tech bust was much more gradual
> than the steep freefall of the last few months. Also, the baby boomers
> who make up the majority of investors are 7 years closer to retirement
> now than they were in 2002, and many still had their funds gambled
> - ahem, invested - in the stock market. Finally, most investors are
> political conservatives, which made 2002 a much more comfortable
> year for them than 2009.
>
> In 2002, you just didn't hear talk about socialism being imminent,
> hyperinflation, a depression, or the end of capitalism as we know
> it. We were all waving our flags, preparing for what we thought would
> be a short, inexpensive war, shifting our investments towards real
> estate, and reducing our savings rate at the suggestion of our president.

Mar 02 02:10 PM

[LeoTheDog:]

I agree, Chris, but I would add another factor: the tech bubble was primarily that: a tech bubble. One could look back on that time and conclude that if you were heavily invested in tech stocks that had triple digit P/E ratios (or no profits at all), you probably took too much risk. As such, there was a simple lesson to take away from the experience.

This time is different (famous words, I know). The scope of the massacre is comprehensive. Everything has gone down. Even "prudent" investors with "diversified" portflolios have taken a beating. What lesson does the average investor take from this meltdown? This one, I fear, will have long lasting negative repercussions for investor psychology. I can't be in stocks, I can't be in real estate, I can't rely on a pension, I can't rely on my company saving my job and I can't rely on my government to provide any reasonable floor.

This time is different; this time it's worse.


On Mar 02 01:52 PM Chris B wrote:

> "The fear created by the second 50% decline is less than the first
> one, which prevents emotion from peaking at the same level as before,
> so it prevents stocks from bottoming at the same level. "
> ----------------------...
>
> I lived through both declines and I'd say the fear is greater this
> time than it was in 2002. For one, the tech bust was much more gradual
> than the steep freefall of the last few months. Also, the baby boomers
> who make up the majority of investors are 7 years closer to retirement
> now than they were in 2002, and many still had their funds gambled
> - ahem, invested - in the stock market. Finally, most investors are
> political conservatives, which made 2002 a much more comfortable
> year for them than 2009.
>
> In 2002, you just didn't hear talk about socialism being imminent,
> hyperinflation, a depression, or the end of capitalism as we know
> it. We were all waving our flags, preparing for what we thought would
> be a short, inexpensive war, shifting our investments towards real
> estate, and reducing our savings rate at the suggestion of our president.

Mar 02 02:31 PM

[Larry House:]

Roger, I hope this is not such a moment as well. I surely do. The market has already brought the unexpected; only time will tell what lies ahead.

Mar 02 02:44 PM

[Vuke:]

Roger, a good question. My father grew up in the shadow of the depression and passed insight of the time to me. "Investors" were looked on wishful thinking fools, akin to wastrels or gamblers. With the exception of dividend paying stocks equities were just not considered as meaningful.

I suppose, psychologically, this mindset was a reflection of the pain so many suffered from the market collapse and subsequent fall-out. If so, we may face much the same over the next twenty years as today's carnage unfolds.

As a broker, perhaps you prepare yourself. As an investor I have by switching to gold. At least I don't have to watch it wither away day by day.

The truly unfortunates are those who have based their pensions and retirement dreams on the waste piles of Wall Street.

Mar 02 02:50 PM

[boats:]

Not to mention the lies of Wall St. Good comment!


On Mar 02 02:50 PM Vuke wrote:

>
>
> The truly unfortunates are those who have based their pensions and
> retirement dreams on the waste piles of Wall Street.

Mar 02 02:59 PM

[Chris B:]

Investment interest will shift to bonds. The treasury bubble is just the beginning.

Suppose you were Japanese in the early 1990's and could see exactly how things were going to turn out on a macroeconomic scale. What should you have bought? With bonds, your yields would have been positive, their value would have been supplemented by deflation, and you would have outperformed the stock market to this day.

Many US investors are coming to the same conclusion. Also, they are graying and looking to decrease risk.

Mar 02 03:12 PM

[cannedpawn8:]

Buy and Hold is gone...I'm a fairly seasoned investor (not trader)...but I'm gone from this market..there is no or very little value being recognized...I'm in cash.

Mar 02 03:15 PM

[Hedge Fund ...:]

Just wanted to add my 2 cents.
Equities won't stabilize until the banking system stabilizes, and the banks can lend again on a proper risk/adjusted basis.
Once that happens, corporate bank debt will stabilize (investment grade) along with investment grade bonds. Then leveraged debt (bank & bonds), then equities.

Absolute priority, in theory, must hold. How can you pay an owner before paying the lender? It's like saying I'd buy a house's equity while the mortgage is still underwater. It doesn't make sense to me.

Mar 02 03:33 PM

[Reggie:]

I knew two people, born early in the 20th Century, that had very little education, never owned a share of stock, wouldn't know what a broker does, nor would they care.

They lived a full life, educating two sons, enjoying grand children, and living and loving with a joy I seldom see today.

These people were my parents.

Perhaps stocks, and the stock market soak up too much of our energy. Perhaps we should LIVE life and not be guided by a financial system that has nothing more to offer than material things.

Mar 02 03:52 PM

[Mayer Amsch...:]

I'm sure that for at least the next few years, stocks won't be the default way to store all of one's long-term funds.
Sadly, however, once markets stabilise, as long as the Federal Reserve involves themselves in pushing down the value of the dollar, therefore artificially inflating the perceived return on equity of all kinds, and government shapes fiscal policy based on what will get the politicians elected, we will have extremes in capital misallocation that will naturally resolve themselves in painful ways; and once the children who are now too young to remember this episode reach investing age, it will likely happen again in the stock markets.

Mar 02 09:18 PM

[zepheri:]

It's more than psychology try demographics and common sense. A huge amount of money is coming out of the market with the boomers retiring for the next 10 - 20 - 30 years. We haven't hardly dipped a toe in that, now much smaller, pile of retirement funds. Since retires have less money they will spend less, dragging all this out, along with the unemployed.
Another layer of this that may seem off subject is we've been trying to control oil/resources with money the world over. In doing this we have stepped on some and have allied with others. People within countries the world over are in disagreement with this. People have lost and profited various amounts on both sides. Are we setting up for a world wide civil war pitting the exploited against the exploiter or are we watching it?

Mar 02 10:04 PM

[rber:]

Everyone can relax. This is not the end of equity investing. It wasn't after the 30's an it won't be now. Greed insures it. There are two things you can always count on in equity investing. Greed and fear. The greed/fear balance has swung to the fear side for now but eventually the balance will return to greed. You can take that one to the....bank?

Mar 03 02:28 AM