SERIOUS MONEY:Senior managers who refuse to accept responsibility should not get another chance, writes Charlie Fell
A TRULY savage year for global equity markets has come to an end and the notion that stocks are the safest asset for medium to long-term investors has taken a severe mauling.
US stocks registered a negative return of 37 per cent last year, the worst showing since 1931, while 10-year Treasuries generated a healthy return of more than 20 per cent as yields dropped from four to 2¼ per cent over the course of the year.
The brutal drop in share prices combined with the first act of the secular bear market eight years ago has seen stocks fail to outpace US Treasuries over the past 20 years in spite of the technology bubble in the late-1990s and the subsequent echo bubble from 2002 to 2007.
Our investment managers failed to recognise that the climate changed fundamentally eight years ago and disregarded the fact that the most recent US economic expansion was not only the feeblest since the second World War but also the most leveraged.
This column warned of the looming danger as did respected academics who argued that the US exhibited all the signs of an economy on the verge of a financial crisis. The buy-and-hold mantra emanating from the bulls on Wall Street was deemed more relevant.
The diehard bulls on this island began the year with extremely bullish equity allocations of more than 75 per cent in so-called medium-risk funds. Some had more than 80 per cent of funds invested in high-risk assets.
The most ebullient managers argued towards the end of 2007 that the developing crisis was akin to the collapse of infamous hedge fund Long Term Capital Management a decade previously and that a US recession was unlikely given the actions of policymakers. Others argued that financial stocks represented a tremendous investment opportunity.
Both investment theses proved embarrassingly wide of the mark as it has since been revealed that the US was already in recession at that point and financial stocks represented an incredible money-making opportunity only for short-sellers.
Though they expressed some concern as the financial crisis gathered momentum, these managers concluded that the economic downturn would be short and shallow, valuations were cheap and missing the likely upturn in share prices was too great a risk. The arguments proved incorrect once again.
Some have since changed their tune and are now advising caution - long after the damage has been done. Of course, talk of caution is one thing and action another. A weighting of 65 to 70 per cent in equities hardly reflects caution.
It has also been argued that current equity valuations are unprecedented. The 70 per cent decline in stock prices in real terms from the high registered in 2000 to the low last November has erased all the valuation excesses built-up during the late-1990s as the price multiple on trend earnings dropped from an unprecedented high of 38 times nine years ago to below 12 times for the first time in more than two decades.
However, of the previous 10 bear markets associated with recession, valuations were lower than today 60 per cent of the time and the market bottomed on single-digit multiples on five occasions.
Current valuations are attractive, offering long-term real returns of 7 per cent following the more than 20 per cent jump in share prices through year-end but they are certainly not unprecedented. Furthermore, the verdict of history suggests that the lofty multiples apparent in the late-1990s and the recent echo bubble will not be seen again for a generation or more.
It is the mean-reverting properties of stock prices that make equities the safest asset for long-term investors, which means stock markets alternate between extended bull and bear market regimes in which the primary determinant of performance is the trend in the price that investors are willing to pay for the market's normalised earnings. The high valuations and bubble-like behaviour of stock prices in 1999 and early-2000 are eerily similar to previous secular market peaks. The carnage that followed should not have surprised as the same proved true of ridiculously high valuations in the late 1920s and 1960s.
The history books also confirm that an echo bubble or miniature replica of the original euphoria was a consistent feature of the early years of previous secular bears. The inescapable conclusion is that lower equity allocations and not weightings of 75 per cent or more were appropriate. The harsh reality is that aggressively overweighting equities during a secular bear market is foolhardy at best and incompetent at worst.
The second act of the secular bear market has pushed many pension funds to the edge of extinction, yet many of the same so-called experts who walked blindly into the first cyclical downturn of the secular remain in high or even higher office today. The blight on the reputation of capitalism seems to go unnoticed.
The lessons of history suggest that a meaningful rally is in the offing at some point but surely the current crop of senior managers should not reap the rewards. Everyone is allowed to fail but for those who refuse to accept responsibility for their actions and fail again, a true capitalist system dictates that a third chance should not be an option.
charliefell@sequoia.ie
