Is it the death of equities? That was the question posed by Peregrine Perspectives to three leading portfolio mangers in a seminar last week. Representatives from Saltus Partners, Cerulli Associates and Cube Capital spoke of their considerations on where the equity markets stand at the moment, the medium and long term views on where they are heading, and the benefits to any portfolio of holding an actively managed fund. The general consensus from their analysis was that the equity markets are not in fact dead, but merely dormant, and have the possibility of staying so for a while to come. In the long term, stock markets are likely to continue seeing the historical growth which has them placed with such heavy weighting in investors minds, however as Jon Macintosh, founder and portfolio manger at Saltus said, “that’s fine if you are going to live to 100, but what about the rest of us?”.
And so one came away from the seminar with a cautious tinge for the future of the stock markets, with some very interesting points to consider when assessing the wider backdrop for potential equity investments
Francois Buclez, Founding Partner and Chief Investment Officer (NYSE:CIO) of Cube Capital, kicked off proceedings with an interesting graph; a century long picture of the Dow Jones Industrial Average. On this graph are highlighted two periods of historical stagnation in the stock index, very clear and each lasting around 20 years. Both of these periods (the first in the 1920’s – 1940’s, the second in the 1970’s to early 1980’s) was accompanied by deflation or inflation, and occurred while the Dow reached a so called ‘round number’, namely 100 in the 1930’s and 1,000 in the 1970’s. This is all very interesting you may well say, but what impact does this have today? Well the graph also highlighted another time period with the same characteristics as these, where potential deflation has met stock market stagnation, with the Dow hovering near the round number 10,000, and that period has been since the turn of the 21st century to today.
If we are in the middle of a 20 year stock market stagnation, how can we make any money, even through a fund? The answer comes, according to Buclez, via the ability of an actively managed fund, to combine and switch between what ever trading and investment method is needed at the time, to turn over a profit. The three broad strategies to generate returns, Buclez cites as Momentum Trading, Return to Mean Trading, and Carry Trading. Momentum trading uses trends and market direction to turn over a profit, Return to Mean utilises strategies such as arbitrage and value convergence to generate returns in a directionless market, and Carry Trading benefits from returns of holding securities with uniform, and hopefully high running yields. The benefits of an actively managed fund therefore are just that; it can be actively managed to use one or all of these strategies to benefit and profit, no matter what the broader market is doing.
Moving back to the equity markets, what signs, the panel considered, can we look out for to indicate the potential return to a bull market? Jon Macintosh made some very interesting observations on just this point. Firstly he considered a cyclically adjusted Schiller price – earnings (NYSE:PE) ratio, over the past 130 years, considering a 10 year average compared to the underlying stock market; the Dow Jones. Averaging around the 16 -17% mark during this period, the PE model currently comes in nearer to 20 – 25%, still too high, Macintosh suggests, for a market recovery. Historically a bull market has occurred when the PE model dipped to around 5%, meaning that either a strong fall in the stock market, or a systematic and sustained increase in earnings, will be needed in the coming years to bring the ratio down to the levels ‘required’ to trigger a bull rush.
Another indicator that Macintosh believes shows a very similar picture, is the ratio of the Dow Jones to the price of gold (inflation adjusted). Again considering this over the past 130 years, with the exception of bull stock market rallies, the ratio has generally hovered around 2:1 (dow:gold). It is in this area where, in a similar vein to that seen in the above PE study, a bull market rally is able to begin. Even with the recent sharp gains in the price of gold, the ratio comes in around 2:9, and further moves are needed to bring it to the point where historically, bull markets have begun. Considering this, Macintosh suggests this effectively means gold prices will need to double form their current levels, a prospect that in light of recent times may not seem as absurd as it once did, or the stock market will need to halve.
In fact looking at the Z Score (effectively considering standard deviations of a number compared to the mean) for a whole range of metrics, over various periods of time, this outlook is mirrored. Compared to the last 30 years, dividend yields, PE’s and the Dow to gold ratio, all show a fairly valued, and even slightly undervalued, stock market. However, looking over a longer period of time, say compared to the average over the 100 years leading to 1980 (effectively discounting form the model the moves made in recent times in order for comparison), the metrics all suggest that the current market is overvalued, a move that may reinforce the view, that stocks have another 10 years of stagnation and depreciation before a true bull market can begin.
So the outlook for equities over the next 10 years is a pessimistic one. Historical trends and cycles suggest we may be in the middle of a secular bear market, and debt deflation cycles (such as the one we are in now) already tend to be harsher than other cycles. According to the speakers at the presentation, equities may still be between 30% and 50% overvalued, which leaves us with a lot of downward potential in the coming years.
This isn’t to say some short to medium term rallies will not be forthcoming, nor that every stock in the world will follow this pattern, however it is something to consider the next time one looks to the stock markets for a long term investment, as the equity markets may very well currently be sleeping.