Odds stack up in favour of equity investment
SERIOUS MONEY: Low valuations and the prospect of a harsh recession make it a safe time to purchase stocks, writes **Charlie Fell **
INVESTORS HAVE suffered intolerable losses over the past 12 months, with most major market averages falling by more than 40 per cent from last year’s peak to the most recent low.
That means a gain of almost 70 per cent on current values will be required simply to restore current values to those pre-slump highs.
A year ago, the idea that part two of the secular bear market that began eight years ago had just got under way was ridiculed. Theories based on experience garnered during the 1980s and 1990s dominated professional thinking.
Twelve months on and the mood has shifted 180 degrees as the bullish ideas have been debunked one by one. The perma-bulls have turned cautious and some optimists have remained noticeably silent as the downward momentum in stock prices gathered pace.
They have seemingly been paralysed by fear as evidenced by bullish sentiment having dropped to the lowest level in decades. The unrelenting flow of bad news means the notion that the global economy is faced with risks not seen since the 1930s has now become mainstream thinking.
It may well be time for contrarian thinkers to put their liquidity to work and selectively accumulate risk assets.
Investors’ mindsets appear to have been shaped by the great bull market of 1982 to 2000, which witnessed the greatest increase in total real stock returns in US financial history.
This extraordinary period saw investors adopt a whole host of half-truths and untruths as conventional wisdom - perhaps none more costly than the mantra that stocks are always the safest asset for long-term investors.
Prof Jeremy Siegel of Wharton demonstrated in his best-selling book, Stocks for the Long Run, that equities have generated a real annual rate of return of almost 7 per cent over long periods with remarkable consistency.
Furthermore, he showed that the variability of stock returns over extended periods has been less than that of government bonds. Unfortunately, this does not imply that stocks are always the asset of choice.
The consistency of stock returns and the resulting decline in the variability of returns over long periods at a more rapid pace than that implied by standard mathematics is clear evidence that stock returns are mean reverting.
Evidence of mean reversion implies that extended periods of stellar performance are followed by long periods involving meagre returns just as night follows day. Indeed, the US stock market has endured seven secular bear cycles since 1802 and is currently eight years into another.
The annualised real return over all seven completed down cycles has been close to zero and given the disastrous stock market performance since the deflation of the technology bubble, the notion that this is a secular downturn is no longer a matter of dispute.
The one defining characteristic at secular bull market peaks - be it 1929, 1966 or 2000 - is excessive optimism, reflected in high valuations that are not conducive to acceptable levels of long-term returns.
The US stock market peaked at 38 times trend earnings eight years ago and probability analysis showed that, at this elevated level, stocks had a less than 50 per cent chance of beating Treasury bonds over 10 years and a one-in-three chance of generating negative real returns over the same period.
The odds were clearly stacked against long-term equity investment and the same was true a year ago, even though the multiple that investors were willing to pay for trend earnings had dropped to 25 times.
Valuation drives long-term returns and paying too high a price for a share of the corporate sector’s expected future cashflows virtually guarantees poor absolute performance as the unfavourable odds take their toll.
Fortunately, the odds have now tilted decidedly in favour of long-term equity investment, with valuations back to levels not seen since 1990.
Stock prices traded on roughly 14 times trend earnings at the recent low, which equates to expected real returns of 7 per cent per annum over the next 10 years or nominal returns of almost 10 per cent per annum. The probability of stocks generating positive real returns in the decade ahead has reached more than 85 per cent, while the odds of equities lagging Treasury bonds has dropped to just 20 per cent.
Although the favourable probabilities have little predictive ability when it comes to timing a market bottom, investors are being presented with a considerable margin of safety when making stock purchases for the first time in almost two decades.
Tactical indicators have also turned favourable. A two-decade low in bullish sentiment, massive mutual fund redemptions and extreme volatility all suggest that the market is washed-out and each indicator is at levels characteristic of major low points in the past.
Furthermore, recent data illustrate that insider buying has increased sharply in recent weeks, with insiders buying nearly two shares of company stock for each one sold.
Finally, the growth rate in high-powered money has begun to soar as the Federal Reserve has stepped up the expansion of its balance sheet.
The economic news has been almost uniformly negative in recent times and the notion that the US faces a harsh recession has rapidly become a consensus. Pronounced investor fear is evident everywhere.
Against the excessive pessimism contrarians, including Warren Buffett, are turning positive.
It is time to be brave and accumulate risk assets selectively.
© 2008 The Irish Times