This week I had the pleasure of meeting with the CEO of a socially important not-for-profit organization. Our conversation turned to dramatic changes in the investment markets in recent years, especially since 2008, when central banks began history's greatest monetary experiment to pull the world's banking system back from the edge of collapse.
The gist of our conversation was that investment consultants, investment committees and others charged with sculpting investment policies and strategies for not-for-profit organizations were unwittingly putting such organizations directly in harm's way by doing business as they have been trained. Our analysis applies equally to retirees or other individuals with largely irreplaceable capital.
Investors who have learned their craft in the past four decades--including a growing cadre of CFAs--have become firm believers in the wisdom of a buy and hold strategy and in the importance of structuring a proper asset allocation to match the risk-bearing capacity of the client. Underlying those beliefs are some fundamental assumptions, born of experience:
1) Don't worry excessively about bear markets; stocks will always come back;
2) Fixed income securities provide a valuable offset to the volatility and risk of equities;
3) Except to meet liquidity needs, cash is trash.
Admittedly, if allowed a multi-decade time frame, the first two assumptions usually prove true. And in most years, stocks and bonds outperform short-term cash equivalents. But there are noteworthy exceptions to these generalizations, and history proves that very few individuals and not-for-profit organizations have the patience necessary to wait out lengthy negative disruptions.
After a five-year, stimulus-fueled stock market rally, investors evidence little fear of surrendering much of their profit. Such confidence is typical when extended rallies have been largely uninterrupted by significant declines. By many measures of investor sentiment, today's investors are more enthusiastic about stock ownership than at any point in more than 100 years, except at the height of the turn of the century dot com mania that was followed by a devastating 50% stock market collapse. The accompanying table shows the destruction done to years of profits from major stock market declines that all began at even lower peaks of positive investor sentiment.
|Stock market decline||Took prices back to||Year former high recovered|
|1907||1897 (10 years)||1916 (9 years)|
|1929-32||1914 (18 years)||1954 (25 years)|
|1973-74||1958 (16 years)||1982 (9 years)|
|2007-09||1997 (12 years)||2013 (4 years)|
When markets fell from earlier peak levels of investor confidence, gains earned in the prior 10 to 18 years were erased. Recovering to former stock market highs took from 9 to 25 years during the twentieth century. With unprecedented Federal Reserve assistance, the recovery took only 4 years from the 2009 market trough, which partially accounts for today's great investor enthusiasm. Should markets fall from the current level of euphoria, it would be highly unlikely that the Fed would be able to provide similar stimulus.
A worst case scenario unfolded in Japan, where the stock market peaked at about 39,000 on the last trading day of 1989. At that time, the Japanese stock market was the largest in the world, and many believed that Japan had discovered the new industrial paradigm. Belief was strong that this would be a one-way market for years to come. While that turned out to be true, the direction surprisingly was down. In a series of lengthy contractions interspersed with rallies, prices fell to below 7,000 in 2009. Even after more than doubling to today's 15,000 level, the index is still more than 60% below its peak and rests at a level first reached in 1986. Past performance and powerful investor confidence clearly do not guarantee even respectable future performance.
In the past, proper diversification and a prudent asset allocation have at least provided some portfolio support when stocks have been weak. Today's investors, however, may not be able to count on traditional support from non-equity securities. Despite interest rates having risen for the better part of the last year and a half, rates are not far above historic lows. There is precious little yield on any but the riskiest bonds. When rates fell to near present levels more than 70 years ago, that marked the kickoff of a four-decade long rising interest rate cycle that lasted into the early 1980s. Over a period of more than 40 years, reasonably diversified bond portfolios failed to keep pace with inflation. Even unmanaged cash equivalents outperformed virtually all bond portfolios over that four-decade span. Having just experienced the exact opposite fixed income environment, with rates falling for three decades until mid-2012, few of today's investors and consultants have experience of multi-year unproductive, even counterproductive fixed income portfolios. If we have seen the beginning of the next rising interest rate cycle, bonds may not only NOT protect portfolios during weak stock market cycles, they may contribute losses, as they did in 2013.
The fact that 1) the U.S. stock market is at historically high valuations accompanied by extreme investor enthusiasm and 2) interest rates are near all-time lows offer reasons why stocks and bonds could be in danger of turning down. Alone, the specter of possible bear markets would not persuade most prudent investors to shy away from traditional diversified asset allocations. There is, however, a far larger concern that should give serious pause to any investor unable to replace lost capital.
We are in the middle of the greatest monetary experiment in history. To rescue the banking system and the broader economy from forecasted collapse, the Federal Reserve Bank and major central banks across the globe have flooded the world with new money. By 2008, over its then 95-year history, the Federal Reserve had acquired debt on its balance sheet of about $800 billion. To stem the financial crisis, the Fed has exploded its balance sheet almost five fold to about $4.5 trillion, with more to come. As Dallas Fed President Richard Fisher has warned, the Fed has no realistic plan to unwind this massive debt burden. Past experience with far smaller amounts in other countries is hardly reassuring. In This Time Is Different, Carmen Reinhart and Ken Rogoff provide copious detail about hundreds of financial crises around the world over the past 800 years. While details understandably differ from episode to episode, some clear conclusions emerge. Governments almost invariably attempt to inflate their way out of debt crises. Occasionally, severe inflation unfolds. In almost all cases, economic growth is markedly stunted for a decade or two before economic normalcy can be restored.
Relative to the size of our economy, the U.S. has reached debt levels at which major problems have unfolded in other countries over the years. And we're not alone. Extreme levels of debt-to-GDP are now typical in most developed countries.
So far, soothing words and promises from central bankers have maintained investor confidence throughout most of the world. But such confidence could shift quickly. Notwithstanding the success of central bank stimulus in boosting stock and bond prices, there has been a far smaller increase in broader economic growth. Many critics of the effectiveness of aggressive monetary stimulus--including some from within the Fed--are arguing for the rapid ending of quantitative easing. It is not at all apparent that the economy and markets can resume historically normal function without such artificial government support.
When assessing potential risks, former St. Louis Fed President William Poole's admonitions should not be ignored. He famously contended that when you look at the numbers, the U.S. is only a matter of years behind Greece, which has survived economically only by the grace of its European rescuers. Should debt levels overwhelm the U.S., there is no rescue net big enough.
The above stated concerns are not forecasts; they are statements of realistic possibilities based on the lessons of history. No one knows how the future will ultimately play out. Some investors, however, are better situated than others are, should worst cases materialize. Those least able to recover from severely negative market environments, especially if consequences persist for a decade or more, may have to forego some significant potential for profit in strong markets to protect against unacceptable losses in the weakest markets, which unfortunately materialize from time to time over the decades. For years, we have urged strongly that investors build flexibility into investment programs in place of the traditional relatively fixed asset allocation approach. The latter will backfire badly if the central bank monetary experiment fails and equity markets fall into a lengthy decline, especially if that equity decline were accompanied by rising interest rates.
Very few of today's consultants and investment committee members have significant professional experience of long lasting weak stock or bond markets, the last of which ended in the early 1980s. As a result, their beliefs have been profoundly influenced by three decades of favorable or at least rapidly recovering markets. An understanding of longer history argues for a more circumspect policy approach by those that cannot easily replace lost capital.
Unfortunately, the common approach to investing today is well characterized by the words of Chuck Prince, former head of Citibank, in explaining the bank's commitment to risk assumption. Acknowledging, in the middle of the past decade, that financial commitments then being made would likely end badly, Prince infamously said that you had to keep dancing as long as the music is playing. The sad lesson, as in the game of musical chairs, is that not everyone gets a safe seat when the music stops. In fact, decades of history demonstrate clearly that the best and brightest in the world's biggest financial firms are almost invariably wrong at every major market top. Should we descend into another lengthy bear market, they won't ring a bell in advance, nor will even the brightest consultants and investment committee members urge greater restraint before the top.
CEOs, CFOs and other senior members of not-for-profits have an additional consideration. Consultants and investment committee members typically cycle in and cycle out, most providing best efforts while there. Should their counsel to structure a traditional investment program result in debilitating losses in a worst case environment, they will eventually move on. It's the top officers and long-term members of non-profits who will bear the stigma of having presided over the loss of effectiveness of that organization's mission if the ability to function as desired is compromised. Unfortunately that scenario has played out in decades past just at the time when weakened economies have placed the greatest demands on social service agencies.
Because it's uncommon to build significant flexibility into portfolios, finding consultants or investment managers with a proven expertise in providing such service is not easy. In the current environment with the overhanging threat of possible failure of history's greatest monetary experiment, prudence suggests that a more intensive search should be worth the effort.