All ingrained beliefs, however deep, face occasional challenges. The trick is to understand whether the challenge is legitimate, in which case we must be willing to revise our beliefs, or opportunist and/or short-sighted, in which case we should not
Long-term investors generally share an ingrained trust that over time equities as an asset class will protect the real value of invested capital. Ultra-long-term studies (eg Barclays Capital’s annual Equity Gilt Study) indicate the outcome can be very much better than mere ‘protection’. How long ‘long term’ actually is or what is meant by ‘over time’ is by general consent taken to be a period of a decade.
Recent experience challenges this view. Sceptics have been able to protest equities have not only failed to offer real protection of capital but have lost nominal value over a decade. This is not meant to happen and has brought, predictably enough, much ill-considered commentary centred on a view that ‘equities are dead’. That the decade has coincided with near-perfect conditions for investors in sovereign bonds is dragged into the mix to demonstrate that perfectly adequate returns can be achieved without the volatility and inherent risks of equity.
Fact or fiction?
The temptation to elevate what may be historically accurate factual observation into a new theory of asset class behaviour is mistaken. The poor outcome from a decade’s investment in equity merely reminds us no theory, however well grounded in logic and empirical observation, will hold true for all time and in all conditions. That we expect returns greater than the ‘risk-free’ rate implies we accept some risk they may not be achieved in any specific period, but by no means is this sufficient evidence to consign the asset class to the bin.
Long-term equity returns – like those of most other risk assets – are derived from underlying economic performance, and the most efficient bridge between overall economic performance and the providers of capital remains the traditional ‘joint stock’ company. Economic growth in capitalist economies (which now means virtually every corner of the earth) is generated by the activities of economic agents ultimately driven by the profit motive. The whole structure has to be substantially funded by capital providers who are willing to accept some unpredictability of returns. By being the last claim on the balance sheet, equity is the essential and rock-solid link.
Better options
History suggests the equity asset class is generally best bought and held, attempts at market timing often eroding rather than adding value. The experience of 2007/08 has shown us a true ‘black swan’ event can destroy value very fast and to a startling degree. Fortunately, black swans do not come along often, but this experience does indicate for the more nervous investor some degree of hedging and at the least some contingency planning is appropriate. That, though, is very different from abandoning the asset class as a whole, not least given the difficulty of answering the question – ‘in favour of what?’.
Core logic insists this asset class represents the most straightforward and effective way for investors with long-term time horizons to protect capital, but it has seldom been more clear there are good – and very bad – times to be raising exposure. So in hard practical terms we need to consider whether today is particularly good or bad. It is neither.
Stock markets have rallied from last year’s lows as investor sentiment has become more rational and better economic metrics have moved from hope to reality. Yet beyond the near-term recovery – which will vary considerably from country to country and region to region – the outlook for the developed world is uninspiring, with activity likely to remain below past trend for an extended period.
Market surprises
Given almost nothing about today’s economic environment can be construed as in any way normal, it may be a mistake to assume ‘normal’ patterns of stock market behaviour are a good guide just now. Despite the recovery, valuations do not appear elevated, even in the light of drab medium-term economic expectations. Investor scepticism is still high, exemplified by $3.3trn still sitting on the sidelines in US mutual money market funds. With so many investors looking for markets to pull back, offering better ‘entry points’, such a pull-back becomes unlikely in the absence of some radical external shock.
The corporate sector came into this economic downturn in good shape, with investors’ share of the cake at high levels relative to other stakeholders, particularly employees. If we look particularly at the US situation one very striking feature of the slowdown has been a continued increase in labour productivity (and a fall in unit wages) – the opposite of past experience. As the inventory cycle bottoms out and maybe then picks up somewhat, the impact on margins can be dramatic. Surprises are what drive markets in the short term. It is quite possible as recession eases corporate earnings may surprise substantially to the upside. This would likely drive equity prices higher.
It is clear, then, today’s circumstances are complex and confusing and the divergence of potential outcomes extreme. But we can at least identify the following:
- The fundamental logic justifying long-term exposure to the equity asset class has not disappeared.
- We have been through an extraordinary and traumatic financial crisis and we have survived. We are well into convalescence rather than immediate crisis management.
- Recessions are abating, as we have been predicting.
- Equities are clearly less ‘cheap’ than they were at their nadir last March, but by normal measures they do not look expensive.
- The strong rally has left many participants behind. This has not felt like an over-enthusiastic bull market: rather, it still feels like a market that will find ample buyers on any weakness.
Given where we have come from and the unfamiliarity of current conditions, the case for equity exposure at this point is not necessarily compelling. Nonetheless, if we combine fundamental logic and empirical observation we must conclude it still looks robust.
Peter Bickley, chief strategist Deutsche Bank, Private Wealth Management
