SERIOUS MONEY:The good news for investors is that the worst of the price damage is over
WINSTON CHURCHILL once quipped that the “farther backward you can look, the farther forward you are likely to see”. His words are frequently dismissed.
The increasing sophistication of modern society alongside our immense knowledge base leads many to conclude that the past holds no relevance for either the present or the future.
This is dangerous thinking. While the tools available to us today may well be beyond historical compare, the psychological make-up of the user has remained virtually unchanged. Mankind moves from fear to greed and back again with great regularity, and in the words of Mark Twain: “History never repeats itself, but it rhymes.”
Stock markets in the developed world are almost nine years into the eighth secular bear market in 200 years and, so far, the present manifestation is going according to acting right on script. The behaviour of stock prices from the peak registered during the spring of 2000 has closely followed the pattern apparent during previous downturns.
The first act of the current bear run had stock prices halve from 2000 to 2002 and was similar in magnitude to the 49 per cent decline from 1906 to 1907, an 89 per cent drop from 1929 and 1932, as well as the 36 per cent fall from 1968 to 1970.
Despite the severity of the fall, investors failed to appreciate that the secular bull market that began during the summer of 1982 had come to an end and continued to believe that equities are the only game in town. Investors generated a miniature version of the last hurrah of the secular bull market or an “echo bubble” that persisted until the autumn of 2007. The pattern was all too familiar in the context of “echo bubbles” which occurred from 1907 to 1909, 1932 to 1937 and from 1970 to 1973.
The existence of “echo bubbles” means that much of the valuation excesses that build up during the heady days of a secular bull run remain, and a further savage fall in prices proves inevitable. The “echo bubble” peaks at a lower level than the previous secular peak and on lower valuation multiples, but it is the sharp drop which follows that brings valuations below their long-term historical average.
This phenomenon has occurred in all historical examples, and the good news for investors is that the worst of the price damage is over. This proved true following the 70 per cent fall from 1929 to 1938 and the 65 per cent drop from 1968 to 1973. The 60 per cent drop in real terms from the high of 2000 is clearly in line with historical experience.
The bad news for investors is that, once valuations dropped below their long-term mean, they remained at “cheap” levels for an extended period. This proved to be the case from 1938 to 1955 and 1973 to 1987. Indeed, real prices went nowhere from 1938 to 1949 and once again from 1974 to 1982, despite seemingly attractive valuations such that all of the real return during these periods stemmed from dividends.
There is no reason to believe that stock market behaviour will prove to be very different during the current secular bear.
Stock prices have not dropped to ridiculously low valuations today unlike previously. Previous secular bears have seen stocks bottom on eight times trend earnings, as against a current low of 12 times. Additionally, 20-year real stock returns dropped below 1 per cent during the earlier bears before a new bull market got under way.
Unfortunately, 20-year real returns today are still running at more than 5 per cent and have only recently dropped below their long-term average. The stock market today does not look as depressed simply because the previous bull saw the most protracted gains and excessive valuations in financial history and as they say, the bigger the party – the greater the hangover.
Projections based on historical experience suggest that stock prices remain vulnerable to a further decline of some 25 per cent from current levels to 600 on the SP 500 despite the battering that investors took last year. Furthermore, stocks are unlike to make serious headway in real terms for a further seven to eight years, and today’s dividend yield at just 3 per cent does not provide as much margin of safety compared to the 5 to 6 per cent yields available in both 1938 and 1974.
It should be clear to investors that a continuing love-affair with equities is inadvisable given that the bear has further to run.
However, the environment could prove rewarding to active investors who adopt contrarian strategies and effect purchases below 800 and sales close to 1,000. Buy-and-hold strategies that worked so well in the 1980s and 1990s are no longer appropriate. Investors must adapt to this new world or go out of business. Welcome to return purgatory.
charliefell@sequoia.ie
