The Road Ahead for Investors

We have just experienced the most bruising capital markets environment since the 1930s—and it may not be over yet. Time will tell. There are pundits who believe that the market is still over-valued and there are those who believe it is under-valued—with everyone struggling to be heard above the noise. The sheer scale of the meltdown is dramatic, but equities are still not at the lowest levels that they have hit in previous calamitous periods. On the basis of some fundamental measures such as trailing ten-year P/E ratios or Tobin’s Q, equities are cheap but could get quite a bit cheaper before they match the fundamentals of previous bottoms. Equities are cheaper than they have been in a long time, many experts note, but they could go lower if past crises are any indication. Well, perhaps this is not exactly a stunning insight. There are plenty of negative voices out there, but it is worth being a skeptic. Nouriel Roubini, the so-called ‘prophet of doom’ who is predicting further market declines, has all of his 401(k) assets invested in equities.

The aggregate risk tolerance of the market has shifted, from an attitude that risk doesn’t really matter as a consideration to one in which investors are very risk averse. It was not so long ago now that retail investors were pouring money into emerging markets, heedless of the historical risk levels associated with this asset class. By their actions, investors were betting that the high risks associated with a range of foreign countries had been conquered—but this idea was not well supported. Today, investors seem convinced that the wheels are—or have a meaningful probability—of coming off the system. As investors sell off their equity holdings, they have invested heavily in bonds. The flight to government bonds, the safest of all asset classes, has created what many see as a bubble in bonds.

If we take a step back, several themes emerge. First and foremost, are there good reasons to suspect that the equity risk premium will be lower in the future than it has been historically? The answer to this question depends on what period of history you happen to look at. The equity risk premium is the additional return that investors have historically obtained by investing in equities (as opposed to risk-free assets). The most readable scholar on the topic of equity risk premiums is Elroy Dimson. He has provided his outlook for the equity risk premium (.pdf) in the Credit Suisse Global Investment Returns Yearbook 2009. His conclusion is that the equity risk premium is likely to be lower in future decades than it was for the 30-year period from 1970 through 2000, but that period was something of an anomaly when you look at the longer record. He estimates that the U.S. equity market as a whole will likely deliver an arithmetic average real return (after inflation is adjusted for) of 6% per year in the long-term. With inflation averaging 3% or so, this puts the total average annual return at 9%. This estimate is a bit higher than the baseline assumption that is used in Quantext Portfolio Planner of 8.3%.

The fundamental approach used by Dimson and others simply based on the idea that the returns from equities must be driven by three factors over the long term: dividends, growth in dividends, and increases in price to earnings (P/E) ratio. Increases in P/E are, by their nature, speculative—they are based on investors’ belief in future earnings growth and other variables. P/E ratios may increase for some period of time, but it would be ridiculous to believe that there is no fundamental constraint. The value of any business comes from its earnings. When Dimson examines these factors across a range of countries, his findings suggest the general level of returns discussed in the previous paragraph.

Historically, markets have swung from one extreme to another—they do not settle into equilibrium. This is why many investors think of markets as a process of Reversion To the Mean (RTM). Periods of outsized equity returns are likely to be followed by periods of low equity returns (and vice versa). This notion rests on the idea of reasonably efficient capital markets—assets are not priced properly at any given instant in time, but they are likely to average to a fairly reasonable price over long periods. This mechanism is implicit in examination of variability in price-to-earnings ratios, dividend yields, etc. as the basis for determining whether stocks are expensive or cheap. Markets have historically cycled between high and low risk tolerance—with investors leveraging or de-leveraging themselves depending upon their outlooks. This process—elegantly described in Minsky’s Financial Instability Hypothesis—has never looked more relevant than in the aftermath of 2008.

While the recent declines in equities have been enormous, they must be put into a long-term context. Over the past ten years (through February 2009), VFINX (Vanguard’s S&P 500 index fund) has generated an average annual return of -2.75% per year, with a standard deviation of 15.6%. Over the twenty years through February 2009, VFINX has generated an average annual return of 7.9%, with a standard deviation of 15.2%. Quantext Portfolio Planner (QPP) uses a baseline estimate of 8.3% for long-term average annual return, with a standard deviation of 15.1%. In other words, the trailing twenty years through February of 2009 has delivered just slightly less return than QPP estimates as “fair”—and we have been using these same baseline statistics since QPP was released—well before 2007-2008. If we push history back just a bit further to 21.5 years (to include the crash of 1987), we end up with an average annual return of 7.2% and a standard deviation of 15.5%. These results suggest that equity investors have actually reaped slightly less than our estimate of ‘fair’ returns over the last twenty years—including 2008. The market goes up, and it goes down, but the last twenty years have actually ended up giving us returns that are consistent with long-term estimates of the equity risk premium. In the twenty-year period through 2007, the average annual return was 11.4% per year, so we can see 2008 for what it was: a substantial case of mean reversion.

What do we make of this? First, there is no way to tell how long it takes for markets to cycle between their extremes. This is why academics like Dimson use a variety of methods to estimate the equity risk premium and don’t just look at historical averages. Over a ten-year period, equities have under-performed the long-term estimate based on the equity risk premium. Over the twenty-year period, equities have delivered 0.4% per year less than the baseline that I use in QPP—but that is actually remarkably close. Jeremy Grantham believes that (.pdf) the S&P 500 is substantially under-valued and a recent comparison between QPP’s and Grantham’s long-term projections showed remarkable consistency. Grantham predicted the relative returns (.pdf) of a range of asset classes remarkably well over the last seven years—so he deserves some attention. Grantham looks at fundamentals and provides tactical asset allocation insight. QPP is primarily a strategic asset allocation tool. When Grantham’s outlook suggests returns higher than the long-term estimates for the equity risk premium, and the historical return on stocks is at or below its long-term average, this would suggest that stocks are attractively priced.

None of this discussion means that equities will not sink further—the market can dramatically swing beyond equilibrium values. Personally, I find the popular practice of ‘calling the bottom’ somewhat ridiculous. I don’t know where the market will bottom out and neither does anyone else. So what does a rational person do? One must start with historical perspective. Experts have been telling us for that the long-term average annual return for equities (based on fundamentals) was much lower than we had experienced during recent decades (prior to 2008). The fact that people ignored this note of caution was no less foolish than people believing that houses could consistently rack up double-digit annual price gains, despite the long-term historical record that showed that residential real estate appreciated at rates slightly better than bonds. The simple reality is that people get too bullish when markets go up and too bearish when markets go down. When I am running portfolio analysis scenarios, I have always used 8.3% per year for the baseline assumption for the arithmetic average annual return for the S&P 500. 2008 has provided more support for the fundamental analysis of equity risk premiums by academics like Elroy Dimson. In terms of layering a tactical component in portfolio planning, I would tend to increase the equity risk premium if I made any change at all—perhaps to be even more consistent with Jeremy Grantham, as I have previously discussed. One of the main reasons why our projections match Grantham so closely is due to a view that risk is coupled across markets (this is a key component of our modeling approach for long-term planning).

My overall conclusions are the following. First, there is a substantial body of research that has been predicting since before 2008 that overall equity prices were too high to be justified based on fundamentals. The massive drops in 2008 among almost all asset classes represents a large scale increase in risk aversion across markets and the associated de-leveraging predicted by Minsky. Going forward, the long-term case for equities as an engine of wealth creation has not been diminished—though many investors may feel this way for quite some time. How long will it take before investors’ appetite for risk comes back? That is not something that I can predict. Events like 2008 are sufficiently rare that they cannot be well described using statistical models. I think that investors re-entering the equity markets will tend to be look for ‘quality’ equities—companies that do not rely on high (and uncertain) estimates of growth to justify their value. I also think that investors will be somewhat less enthusiastic with regard to emerging markets now that they realize that the old ‘decoupling’ story was simply not true. This does not mean that it is rational for investors to have far less weight in emerging markets—but this seems likely.

The enduring point that 2008 makes so clear is how powerful a role psychology plays in the minds of the collective market participants. Not so long ago, investors could see no end to their amazing returns from emerging markets. Before that it was housing. Before that it was tech stocks. Momentum cannot persist in one direction forever. While Grantham pointed out prior to 2008 that we were in a ‘risk bubble’—where investors simply wanted more and more aggressive portfolios—we are now in a ‘risk aversion bubble’---investors are petrified of taking on or holding risky assets. Another fairly disturbing feature of the current market is that investors seem to have largely discounted inflationary pressures—nominal bonds are the least attractive asset in an inflationary environment. There will always be a general over- or under-enthusiasm for different asset classes, sectors, etc.—this is the nature of markets. There are ways to exploit any particular bias in the market. When markets are insufficiently risk averse—as they were in the years leading up to mid 2007—investors can stay out in front by owning more defensive assets. When markets are exceedingly risk averse, investors can bet against this risk aversion. Even if we are correct in these tactical moves, however, the timing is challenging—gambler’s ruin is a risk for everyone.

Before concluding, I hasten to note that I took my lumps in 2008. I am by no means claiming to have been prescient in seeing this disaster coming. The general trends in this market certainly weight to the mean reversion view of the world, however. Volatility has reverted to its long-term average (about 15% for the S&P 500) and the equity risk premium is in line with its long-term average. Going forward—in the long-term—the statistics suggest that (1) equities will recover, (2) bonds will decline, and (3) inflation will return. We cannot know the timing of these things—but that uncertainty is what we, as investors, are being paid to take on.

Comments

[Chris B:]

Good points. It was the peak, not now, that was the prime time to move to more conservative assets. Near the bottom is the prime time to take on risk.

The market prediction of zero inflation for a decade is ridiculous. Buy TIP with your safety money.

Mar 24 02:27 PM

[Lee Eugene ...:]

Very nice article, with a lot of solid research. I agree with you that 2008 was a "mean reversion" year--this is just a fancy way of saying that all bubbles have to burst (I suppose real bubbles, like bubble gum ones, can be carefully deflated, but that's not the way markets work). What I'm worried about in your analysis is a lack of consideration of the market consequences of large-scale political manipulation. Say the market stops falling soon--a good thing, no doubt. But if the reason it stopped falling is because we used a bunch of new public money to boost it, even if the nominal value of our portfolios goes up, in real terms, how do we know we aren't getting poorer. Chris B is right, but I'm not sure yet TIPs are the answer, since we may, as you noted, have just created a new bubble in government bonds. This isn't how free markets work, at least not for long.

Mar 24 03:22 PM

[E.D. Hart:]

We cannot be nearly certain that Inflation will return, bonds will decline, and that equities will recover.

Investors confuse risk with uncertainty.

There is much uncertainty in the markets regarding the timing of the recovery of oil prices, but I can be nearly certain that prices will be higher five years from now, just as I can be nearly certain of the recovery of inflation five years from now.

Betting on oil stocks for example is high in uncertainty, but low in risk.
Geoff, great article, as always. Thank you.

Mar 24 03:51 PM

[E.D. Hart:]

"We cannot be nearly certain that Inflation will return, bonds will decline, and that equities will recover. "

Meant to say, "We can be nearly..."

Mar 24 03:53 PM

[Fred Voetsch:]

"Markets have historically cycled between high and low risk tolerance—with investors leveraging or de-leveraging themselves depending upon their outlooks."

And then there are periods where investors deleverage based upon NEED rather than outlook. If our economy is at a bottom and things begin to get better then you can believe that investors will leverage up again but if you believe that unemployment will grow and the economy will continue to struggle then the deflationary spiral will cause a NEED to deleverage from investments (to pay bills) and from housing and pricey vehicles (to reduce debt) and from all sorts of other things we don't really need that we thought, just a few short months ago, that would could not live without.

Mar 24 04:51 PM

[Fred Voetsch:]

On Mar 24 02:27 PM Chris B wrote:

> Good points. It was the peak, not now, that was the prime time to
> move to more conservative assets. Near the bottom is the prime time
> to take on risk.


Well...yes, but where's the bottom? If you invest in the stock market here and it goes to 1,500 and doesn't come back to this level for 15 years then you have a problem.

A bottom 50% lower than the top does not provide for a huge rally while a bottom 90% lower than the top is almost certain to give a big bounce, in percentage terms. Once again I ask: where's the bottom?

At this level there is no great upside and yet the downside potential is huge, in percentage terms. I can make a great case for the Dow going to 1,200 and not reaching 7,000 again for ten years and I will back it up with a lot of data. That does not mean it will happen but have you seen another period in history where an entire society has been as leveraged up as we are?

Do you want to lose all your money AND your job? I would say it is wiser for most to hedge to the downside and if the economy improves you might not care if you lost a bit of your investments while if it gets much worse you then have some backup.

All I am saying is that "we can't go much lower" is not a wise investing strategy. Each of us should consider various possible scenarios and act accordingly and not just rely on hope or recent past experience or on the advice of people who only want to sell us something.

Mar 24 05:03 PM

[Happy Gillmor:]

Excellent article. Nothing I would disagree with at all. I wish all my clients read this! Thank you.

Mar 24 05:32 PM

[User 382367:]

You misunderstand Reversion to the Mean. Statistically, it does *not* imply that excessive highs will be canceled by excessive lows, or vice-versa. Reversion to the Mean simply implies that excessive swings are more likely than not to be followed by average behavior, hence the long-term average tends to be stable. That's not to say that markets conform to the statistical principle, but that principle is not what you imply it is.

Mar 24 06:50 PM

[jstratt:]

I enjoy Geoff's contributions. His Quantext Portfolio Planner is also an excellent tool. Those wanting to assess their portfolio risk more accurately should give it a try.

Mar 24 07:03 PM

[Flav:]

Geoff, great article (as always). You made me wait almost a month since the last one you wrote, please write more often!! :)

Mar 24 07:45 PM

[mac.barron:]

For the second time in this decade the U.S. markets have basically lost fifty per cent of their value. Sophisticated SeekingAlpha type investors know how to trade under adverse conditions so a lot of us have made money going up and going down. Sad thing is a lot of just plain folks did the by-and-hold thing and now have lost most of their retirement money.

Looking ahead I do believe that the value that Main Street investors will be willing to place on the market will be less. Granted they do not pilot the ship, but their likely skittishness will be a factor. This effect will only be amplified by the inflation that is in the offing. The anger that we have seen expressed by john Q. Public so far will seem mild in comparison to the next few levels that will follow from the current monetary policy.

Mar 24 10:42 PM

[H. E. Canada:]

I thoroughly enjoyed your post, Geoff. It is full enough of caveats and disclaimers to validate your advisory position. Seriously, your arguements for equities being attractive are persuasive and your references substantial.

The issue of market timing somehow always inserts itself into these discussions. As you say, " ... the timing is challenging—gambler’s ruin is a risk for everyone." Obviously, individual equities are always a stock-pickers game.

Concerning the broad market, however, it is a different story. RBC Capital Markets has an interesting table comparing entering into the market 3 and 6 months before "the bottom" versus 3 and 6 months after. The apparent argument for waiting for the turn impresses me. Find the table here: lh4.ggpht.com/_Iz4sLjj...

One statement you made I cannot substantiate: "Volatility has reverted to its long-term average (about 15% for the S&P 500)." From where does 15% come? The VIX closed today at 42.93. Do I misunderstand something here?

Mar 25 12:35 AM

[No Free Cake:]

I like reading Geoff's articles, and I bought his QRP, but, it still puzzles me why he and so many others necessarily think US equities must go up in any reasonable timeframe.

Japan's Nikkei index is lower today than it was 25 years ago. Certainly there were some tradeable peaks and valleys for the nimble and lucky but counter to the idea of rising equities. What is so intrinsically different about the US that this couldn't happen here?

In other words, just because the line has been going up for some time, why must it continue to do so?

Mar 25 12:48 AM

[Fighting Yoda:]

"....(1) equities will recover, (2) bonds will decline, and (3) inflation will return. We cannot know the timing of these things—but that uncertainty is what we, as investors, are being paid to take on...."

However difficult, if not downright impossible – you have to time the market or at least get the direction right. Eventually will recover could be fools game – will Nasdaq go to 5000 – highly unlikely even 3000 in the next 5 years, you may have bought Nasdaq on its way down from 5K at 3K or 2K and could still be way down. The biggest losses in this downturn have been incurred by those that picked the bottom too early and doubled down – likes of Ken Heebner, Bill Miller, even Buffet, etc.
Nikkei went down from the peak of 39K in 1989, to recover back 18 years later in ’07, to only to 18K. Now back to 8K – the levels of 1982. So “eventually it will recover” is not at all necessarily true. Once Tulip mania is over – no one wants to pay a dime for it. We likely will go through a phase of equity aversion – likely to last several years, valuations will not matter. Beauty is in the eye of beholder – if no one wants something, its price can fall and stay there forever.

You may not get it right but still need to forecast the bottom within +/- 5 or 10%, and act on it. My personal forecast for S&P is 500 – 10x$50. I will start buying at 550 and will average with the market – up or down. I am not enamored by these govt. inspired rallies – they will fade quickly as so many in the recent past.

Mar 25 12:59 AM

[Harry Tuttle:]

Your reference to Roubini's portfolio is both irrelevant and misleading and it detracts from an otherwise interesting article.

Nobody knows where the bottom is and that includes Roubini and Jeremy Grantham.

I think that you are correct in the sense that equities should not be abandoned as they will, one day, perform again. However, a market that goes down 90% goes down 80% and then 50%, so there is nothing magical about S&P 666 or 800.

The reasonable approach, in my opinion, is to have a balanced portfolio which means the days of 60-100% equities should be over. I know, however, that they will be back as it is human to repeat the same mistakes over and over.

By the way, there is no bubble in bonds. Only treasuries.

Mar 25 09:02 AM

[Chris B:]

On Mar 24 05:03 PM Fred Voetsch wrote:

"Well...yes, but where's the bottom? If you invest in the stock market here and it goes to 1,500 and doesn't come back to this level for 15 years then you have a problem."
----------------------...
Nobody worries much about the possibility of the market going down until it already has. Past performance is no indicator of future performance, yet our expectations rarely deviate far from the exact same outcome that happened the previous year. The rear-view mirror has never predicted the future before, yet for some reason we can't help ourselves but to rely on it. If you must look at history, look at index performance during the year or two following double-digit % declines.


"...have you seen another period in history where an entire society has been as leveraged up as we are? "
----------------------...
In terms of national debt to GDP, we were in a far deeper hole in the post WW2 period (which was a great time to buy stocks). Over several years, this debt was paid down to lower levels. I'm sure there were dire predictions at the time too!

In terms of household debt, the peak was a few years ago. Now the consumer savings rate is 3% and rising. That's mostly going towards paying down debt. Meanwhile credit card limits, auto loans, etc. are becoming more conservative. Consumer debt will continue to fall. Also, people taking advantage of once-in-a-lifetime low mortgage rates like we have now does not constitute a crisis, it constitutes wisely locking in low payments for the future.


"Do you want to lose all your money AND your job? I would say it is wiser for most to hedge to the downside and if the economy improves you might not care if you lost a bit of your investments while if it gets much worse you then have some backup."
----------------------...
Nobody should put every penny into the stock market, as wild price fluctuations are typical. I hold enough cash to get through 1-2 yrs of unemployment, good times or bad, and self-finance home improvement and big purchases rather than taking out loans. The only money you should have in stocks is money you won't need to access for 10 yrs. Yet, many people are advocating fleeing the markets just because prices went down. That's not the thinking of successful investors.


"All I am saying is that "we can't go much lower" is not a wise investing strategy."
----------------------...
Who needs hope when you can analyze a company's financials, estimate future earnings, and produce a reasonable estimate of the present value of future earnings, discounted by bond yields plus risk premia? Many investors have no interest in this kind of homework, and thus they are implicitly relying on the markets to tell them what an appropriate price for an investment is. I'd say that efficient markets theory is the unwise investment strategy, especially if it is followed up by selling anytime paper losses are experienced.

Mar 25 11:23 AM

[Henry Buttal:]

Another great article! Thanks for the insight. Who knows, maybe I will be able to afford QPP one of these days.

Mar 25 12:14 PM

[Andy Abraham:]

Zero Inflation is a dream... the ABCs of economics ...when govts print... Inflation the wealth destroyer raises it's ugly head... watch out... have a plan.. otherwise Inflation can wipe you out...

Mar 25 04:11 PM

[Geoff Consi...:]

Guys:

Thanks for all of the thoughtful comments. The spread of thinking that you all have expressed mirrors what everyone feels--the balance between long-term statistics and the current view based on the specifics of the situation. I am not an raging bull--that should be clear. When I look around, there are clearly some serious issues and we don't know where things will go from here in the near term. If the government persists in propping up bad banks, we could see a situation like Japan--with a sort of 'walking dead' market for quite a few years. We are in a remarkable situation--think about oil--going from $145 to about a third of that in just a few months. The degree of deleveraging is amazing. A great deal of how one responds to this market will depend on the rest of one's portfolio (human capital, household debt, etc.). If we see a prolonged period of deflation, debt will overcome many more investors. When the market reverts to double digit inflation for some period (as I fear it will), we will see investors with high allocations to FI lose purchasing power. I have no problem with the notion of timing, but it is very dangerous to ignore the possibility that your timing may be wrong. In the same way that so many people went high Beta and disounted risk before 2008 (ignoring all other risks), there is a peril in having too much faith in your own singular view--whether its the potential of emerging markets or to discount inflation or to shun market risk.

Anyway--thanks for this dialog.

Geoff

Mar 30 10:30 AM