Bear markets have a way of breaking investors’ spirits—even their ability to rationally analyze capital markets. Take for example the period from about 1965 to 1982: The Dow Jones Industrial Average was essentially stagnant, trading in a range that gave birth to the rule of thumb, Buy at 500, sell at 1,000. By August 1979, a Business Week cover story asked, “Are Equities Dead?”
Investors have been laughing at that cover story ever since, because the greatest bull market in history was just around the corner. But, in truth, we shouldn’t mock Business Week. The Dow didn’t surpass 1965 levels until the fall of 1982. And, besides, with the Dow bumping around in a trading range as cramped as a broom closet, and the economic climate so brutal that it gave birth to the stagflation phenomenon, rational people can be forgiven for having had irrational thoughts. “Yes, this time is different,” they thought, predicting that returns on a number of asset classes might never revert to the mean. (Remember gold’s lost two decades?)
Well, it looks like we are at it again. With the exception of a recent rally, equity indices have been on a downward tear since peaking in October 2007, with the Dow breaking below 8,000 back in early February, and the S&P 500 sinking under 900 in early January. Housing hasn’t bottomed, credit markets are far from healed, government stimulus programs are only just beginning and thus won’t take effect for some time, unemployment is still rising, and European and Asian economies look worse than ours. In short, the economy is a mess, while reclaiming 10,000 on the Dow still looks like a very distant possibility. Many people are finding the words “paradigm shift” on their lips once again, and accordingly, the debate over what is next for the markets has spawned some interesting challenges to accepted wisdom.
Some loud bears are saying this time is really different…that the equities game has changed, that reversion to old historical means is dead. And they don’t mean this month or year—they mean forever (sound familiar?). In fact, some fund managers and financial analysts say the long-term risk premiums on equities have disappeared; they go so far as to tout the merits of all bond portfolios—and not just for retirees.
Bill Gross, who’s April Investment Outlook letter titled, “The Future of Investing: Evolution or Revolution,” will chasten any ardent bull, writes that “the future of investing will depend on the long-term future of the global economy.” What’s in store for the global economy? Deleveraging, de-globalization and re-regulation, says Gross, none of which are good for equities. And anyways, he says, for the past 10, 25 and 40 years, total returns from bonds have exceeded those for common stocks, according to research from Research Affiliates. (How bearish on stocks is Gross? In a recent interview, he said he sold his entire equity portion of his portfolio—40 percent—roughly one year ago.)
Meanwhile, two interesting studies have recently been released, further challenging the supremacy of stocks in an investment portfolio—and not from crackpots with suspect backgrounds. In mid-February, Lubos Pastor, a finance professor from the University of Chicago, and Robert Stambaugh, a finance professor at Wharton, published a revised version of their 2008 study titled, “Are Stocks Really Less Volatile in the Long Run?” The answer they say is, in short, no. The paper challenges a central tenet of investing: That if you hold stocks for the long run, you will get paid for the risk you take. They turn the concept of variance upside down: It’s the short-run that is more certain, the paper argues. Reversion to the mean isn’t a strong enough factor to overcome the uncertainty caused by other factors as the timeframe increases. Here is their conclusion: “Stock volatility is greater [over] long horizons than [over] short horizons, thereby making stocks less appealing to long-horizon investors than conventional wisdom would suggest.” They acknowledge the finding “doesn’t necessarily imply” that long-term investors should hold less stock than short-term investors, and that volatility is only one “key ingredient” in the problem of asset allocation. (But that conclusion is shocking, if it holds up under further scrutiny.)
Then there’s research titan, Rob Arnott, chairman of Research Affiliates, credited as the creator of fundamental indexing. Arnott has further upset the received wisdom around the value of stocks in an investment portfolio. In an article titled, “Bonds: Why Bother?” to be published in April in the Journal of Indexes, Arnott challenges the central tenet of investing orthodoxy: that stocks provide a 5 percent risk premium to bonds over the so-called long run. John Mauldin, president of Millenium Wave Advisors, an RIA, and writes a regular investment newsletter called, “Thoughts from the Frontline,” has also joined in the debate. Mauldin shares some juicy portions of Arnott’s 17-page research paper in his March 28th letter to his readers. In short,
Arnott calls the 5 percent risk premium a “myth.” In fact, Arnott says it’s closer to half that looking back over 207 years of data.
The last 40 years (long run enough?) have been particularly brutal: From 1980 to 2008, an investor in 20-year Treasuries, rolling them over every year, beats the S&P 500 through January 2008. Going back to 1969, bond investors still win. The 2.5 percent premium, says Arnott, is due to inflation averaging 1.5 percent that trimmed real returns on bonds while earnings and dividends boosted real returns of stocks by 1 percent.
So, are these gurus right? Is this a paradigm shift or are the dire predictions a sign that a bottom has been reached, a sign that (bulls, wait for it…) it is, in fact, time to buy stocks? Jeffrey Saut, Raymond James’ chief investment officer, says after making some handsome gains since the first week of March when he was a buyer of stocks and indexes, he’s now taking profits. Still, Saut remains cautiously optimistic. He expects the March “buying stampede” that rocketed the Dow up 24 percent to fizzle in the next several days as history suggests it will. According to Saut, the majority last between 17 and 25 sessions before the fear of being out of the market overcomes the fear of being in it. He’s waiting for a 2 to 3 day pullback as a sign it’s truly over.
For the long-term, Saut says he’s keeping a close eye on two primary economic indicators for signs of this bear market’s true bottom: credit spreads and personal consumption expenditures (PCE). “Credit spreads had improved up until today,” Saut says, speaking after the market’s pullback on Monday (March 30). He says that while the spread between three-month dollar LIBOR and the three-month overnight index swap (OIS) rate had fallen to 150bps recently, he’d like to see it move closer to 50bps. As for PCE, it had gone down but had bumped back up in the last two reporting periods, he says. A stabilized PCE means the end of the recession isn’t far off, says Saut, but those two bumps may have been less than they seem because of two factors: the government’s 5.8 percent cost of living adjustment in January as well as a 13.2 percent increase in IRS tax refunds year over year. Says Saut: “If the stampede is over, what happens next? Will the markets go sideways? Or will we go down again and test the lows? I don’t know.” (For more on Saut’s thinking, click here.)
