SERIOUS MONEY:Heeding the advice of those whose livelihood depends on bull markets is rarely wise, writes CHARLIE FELL.
THE FIRST quarter is at a close and stock markets have ended in the red once again with US market averages recording a double-digit decline since the start of the year. However, equity prices have jumped almost 20 per cent from the most recent bear market low registered early in March and have posted their best month since the market bottom in October 2002.
Not surprisingly, the favourable price action has seen a number of perma-bulls leave their trenches to declare the birth of a new bull market.
Stock prices may well have bottomed but investors should be aware that the same motley crew have called a turn incorrectly several times over the last 15 months and those who heeded the advice now require miraculous performance just to break even.
Abby Joseph Cohen, the queen of irrational market exuberance during the late-1990s, advised clients at the start of 2008 that stocks would reverse course and post double-digit gains for the year. The market averages had not as yet entered bear market territory but soon would and had more than halved by the time prices hit their most recent bottom last month. Stock prices must now double for her clients to recoup their losses.
Cohen was not alone. Wall Street seers declared a bottom following the failure of Bear Stearns last spring, the travails of Fannie Mae and Freddie Mac alongside the demise of Lehman Brothers in the autumn, and finally upon the election of Barack Obama late in the year.
The premature investment calls resemble the persistent bullishness throughout the market drop from 2000 to 2002 and echo similar pronouncements during the crash from 1929 to 1932 that are now held up to ridicule. The lesson for investors is surely that heeding the advice of those whose livelihood depends on bull markets is rarely the best course of action.
There is no doubt that the massive wealth destruction experienced by equity investors has seen valuation multiples drop to levels that historically can be described as attractive. Indeed, the price/earnings multiple on trend earnings dropped to 10 times early in March, the lowest reading since 1984 and six points below the long-term mean.
The historical data reveals that multiples from seven to 10 times have been followed by 10-year real returns of roughly 6 to 8 per cent and the results are statistically significant.
It is clear that valuation drives long-term performance but adds little to performance over shorter horizons. The market traded on eight times trend earnings at the bottoms in 1938 and 1974 but investors were not rewarded with outsized capital gains through the final years of the respective secular bears. Indeed, the stock market, apart from the usual cyclical peaks and troughs, essentially traded sideways in real terms from 1938 to 1949 and once again from 1974 to 1982.
Healthy returns over each period were only earned as a result of the respectable dividend yields of 5 to 6 per cent on offer.
The savage decline in stock prices has seen valuation multiples drop below their long-term mean for the first time in a generation but the historical evidence reveals that they are likely to remain low until well into a new secular bull. The price/earnings multiple on trend earnings dropped below 16 times in 1938 and did not exceed that level until 1955. Similarly, the multiple fell below its long-term mean in 1973 and remained below average until 1987. Neither case should be particularly surprising because this is how variables with mean-reverting properties establish the long-term average.
Twenty-year real price returns recently dropped below 2 per cent for the first time since 1993 and, though this may appear low to some, it has in reality only fallen to the historical average, which as one should expect, tracks the long-term growth rate in real earnings per share.
A return only to the historical mean, despite a 65 per cent fall in real prices since 2000, demonstrates how powerful the previous secular bull truly was. In contrast, the end of the secular bears in 1949 and 1982 saw 20-year real price returns five and almost four percentage points below zero respectively.
The annals of history also reveal that the duration of the secular bear should it have come to an end in March would be unusually brief.
The median of the eight previous structural downturns over the past two centuries is 15 years. The current nine years would be the shortest since the eight-year affair from 1853 to 1861. It would appear that the current incarnation could easily run for another six years with real prices gaining little ground whatsoever. Indeed, such an outcome would see long-term real price returns drop to zero and valuation multiples to levels consistent with the bottom of previous secular bears.
Declarations that a new secular bull has begun seem premature. Large rallies from deeply oversold levels are to be expected but it is clear that selling pressure remains high while long-term fundamentals from re-regulation to soaring public sector deficits are hardly a prescription for a secular bull. It is too early to advocate a “buy-and-hold” strategy as the market is likely to remain range-bound for a protracted period.
Perhaps the market seers should heed the words of Lao Tzu: “Those who have knowledge don’t predict; those who predict don’t have knowledge.”
