The Coming Mega-Bull Market?

March 2, 2014

Investor behavior has a lot to do with how markets behave, and with how investors perform.  To profit from a long mega-bull market, investors have to be willing to buy stocks and hold them through the inevitable ups and downs along the way.  Risk tolerance greatly influences their willing to do that—and risk tolerance is greatly influenced by their past experience.

From an article on risk in The Economist:

People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.

But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.

The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”

I’ve bolded a couple of sections that I think are particularly interesting.  Investors who came of age in the 1930s tended to have an aversion to stocks also—an aversion that caused them to miss the next mega-bull market in the 1950s.  Today’s investors may be similarly traumatized, having just lived through two bear markets in the last decade or so.

Bull markets climb a wall of worry and today’s prospective investors are plenty worried.  Evidence of this is how quickly risk-averse bond-buying picks up during even small corrections in the stock market.  If history is any guide, investors could be overly cautious for a very long time.

Of course, I don’t know whether we’re going to have a mega-bull market for the next ten or fifteen years or not.  Anything can happen.  But it wouldn’t surprise me if the stock market does very well going forward—and it would surprise me even less if most investors miss out.

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Equity as the Way to Wealth

January 3, 2014

According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth.  I find that quite distressing, and not just because stocks are my business.  Stocks are equity—and equity is ownership.  If things are being done right, the owner should end up making more than the employee as the business grows.  I’ve reproduced a table from Gallup’s article below.

Source: Gallup  (click on image to enlarge)

You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.

Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance.  In the article, they asked 40 prominent people about the best financial advice they’d ever received.  (Obviously you should read the whole thing!)  Two of the comments that struck me most are below:

Charles Schwab, chairman of Charles Schwab Corp.

A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.

Richard Sylla, professor of the history of financial institutions and markets at New York University

The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.

The advice was to stash every penny of our university retirement contributions in the stock market.

As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.

We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”

Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.

Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.

At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.

Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market!  Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold!  I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth.  His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working!  (The italics in the quote above are mine.)

Equity is ownership, and ownership of productive assets is the way to wealth.

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Stock Market at All-Time Highs

December 2, 2013

“I can’t buy now—the stock market is at all-time highs.”  I’ve heard that, or some version of it, from multiple clients in the last few weeks.  I understand where clients are coming from.  Their past experience involves waiting too long to buy and then getting walloped.  That’s because clients often wait for the bubble phase to invest.  Not only is the stock market at all-time highs, but valuations tend to be stretched as well.

Here’s the thing: buying at all-time highs really doesn’t contain much information about whether you are making an investing mistake or not.

For proof, I will turn to a nice piece in Advisor Perspectives penned by Alliance Bernstein.  Here’s what they have to say:

With the US stock market repeatedly reaching all-time highs in recent weeks, many investors are becoming leery of investing in stocks. Focusing on the market’s level is a mistake, in our view. It’s market valuation, not level, that matters.

Since 1900, the S&P 500  Index has been close to (within 5%) of its prior peak almost half the time. There’s a simple reason for this. The stock market goes up over time, along with the economy and corporate earnings.

Fear of investing at market peaks is understandable. In the short term, there’s always the risk that other investors will decide to take gains, or that geopolitical, economic or company-specific news will trigger a market pullback.

But for longer-term investors, market level has no predictive power. Market valuation—not market level—is what historically has mattered to future returns.

They have a nice graphic to show that investing near the high—or not near the high—is inconsequential.  They show that future returns are much more correlated to valuation.

Source: Advisor Perspective  (click on image to enlarge)

I’m no fundamental analyst, but commentators from Warren Buffett to Ed Yardeni to Howard Marks have suggested that valuations are reasonable, although slightly higher than average.  There’s obviously no guarantee that stocks will go up, but you are probably not tap dancing on a landmine.  Or let’s put it this way: if the stock market goes down from here, it won’t be because we are at all-time highs.  The trend is your friend until it ends.

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Stock Market Valuation

May 7, 2013

Stock market valuation is always a concern for investors.  Presumably it always helps to buy when valuation is low.  However, I’m no expert on stock market valuation.  In the past, I’ve shown some bottom-up valuations constructed by Morningstar analysts.  They suggest the market is fairly valued right now.  Another way to look at it is top-down; that is, taking the big picture view of valuations.

That’s what Ed Yardeni of Dr. Ed’s Blog does.  From a big picture perspective, there are just two main variables in stock market valuation: earnings, and the multiple you put on those earnings.  Lots of firms estimate aggregate S&P 500 earnings.  (Top-down estimates actually tend to be a little more accurate than bottom-up estimates.)  In this version, he uses the Thomson Reuters IBES estimate.  For his estimate of the appropriate multiple, he uses 20 minus the 10-year yield.  That kind of thinking makes sense.  With low interest rates, the market has typically traded at a higher multiple.  When interest rates or inflation are high, the PE multiple tends to get compressed.  He points out that other versions of this chart, like using a multiple of 20 minus CPI inflation come out in the same ballpark.

Here’s the chart from his recent article on valuation:

Source: Dr. Ed’s Blog    (click on image to enlarge)

It’s an interesting chart, is it not?  Based on earnings, it suggested the market was significantly overvalued in the late 1990s, and then fairly valued from 2002 to 2007 or so.  The market dropped appropriately in response to weak earnings during the financial crisis, but is now about 30% undervalued, not having kept up with the rapid earnings growth we’ve seen since then.  The suggestion is that if earnings hold up, current stock prices are not out of line with the past decade.

It’s well worth reading the rest of the article, as Dr. Yardeni also discusses the relative valuation of stocks versus bonds.  (The whole blog is worth reading!  He is one of the more practically grounded economists out there.)

My takeaway on this is simply that the current market may not warrant the incredible amount of hand-wringing that we’ve seen as the S&P 500 has pushed to new highs.  Given the powerful corporate earnings we’ve seen, coupled with very low interest rates, the market’s valuation may be reasonable.  Yes, it feels scary because we are in new high ground, but the data looks different than we might feel emotionally.

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Target Date Fund Follies

March 7, 2013

Target date and lifecycle funds have taken off since 2006, when they were deemed qualified default investment alternatives in the Pension Protection Act.  I’m sure it seemed like a good idea at the time.  Unfortunately, it planted the idea that a glidepath that moved toward bonds as the investor moved toward retirement was a good idea.  Assets in target date funds were nearly $400 billion at the end of 2011—and they have continued to grow rapidly.

In fact, bonds will prove to be a good idea if they perform well and a lousy idea if they perform poorly.  Since 10-year future returns correlate closely with the current coupon yield, prospects for bonds going forward aren’t particularly promising at the moment.  I’ve argued before that tactical asset allocation may provide an alternative method of accumulating capital, as opposed to a restrictive target-date glidepath.

A new research paper by Javier Estrada, The Glidepath Illusion: An International Perspective, makes a much broader claim.  He looks at typical glidepaths that move toward bonds over time, and then at a wide variety of alternatives, ranging from inverse glidepaths that move toward stocks over time to balanced funds.  His findings are stunning.

This lifecycle strategy implies that investors are aggressive with little capital and conservative with much more capital, which may not be optimal in terms of wealth accumulation. This article evaluates three alternative types of strategies, including contrarian strategies that follow a glidepath opposite to that of target-date funds; that is, they become more aggressive as retirement approaches. The results from a comprehensive sample that spans over 19 countries, two regions, and 110 years suggest that, relative to lifecycle strategies, the alternative strategies considered here provide investors with higher expected terminal wealth, higher upside potential, more limited downside potential, and higher uncertainty but limited to how much better, not how much worse, investors are expected to do with these strategies.

In other words, the only real question was how much better the alternative strategies performed.  (I added the bold.)

Every strategy option they considered performed better than the traditional glidepath!  True, if they were more focused on equities, they were more volatile.  But, for the cost of the volatility, you ended up with more money—sometimes appreciably more money.  This data sample was worldwide and extended over 110 years, so it wasn’t a fluke.  Staying equity-focused didn’t work occasionally in some markets—it worked consistently in every time frame in every region.  Certainly the future won’t be exactly like the past, so there is no way to know if these results will hold going forward.  However, bonds have had terrific performance over the last 30 years and the glidepath favoring them still didn’t beat alternative strategies over an investing lifetime.

Bonds, to me, make sense to reduce volatility.  Some clients simply must have a reduced-volatility portfolio to sleep at night, and I get that.  But Mr. Estrada’s study shows that the typical glidepath is outperformed even by a 60/40-type balanced fund.  (Balanced funds, by the way, are also designated QDIAs in the Pension Protection Act.)   Tactical asset allocation, where bonds are held temporarily for defensive purposes, might also allow clients to sleep at night while retaining a growth orientation.  The bottom line is that it makes sense to reduce volatility just enough to keep the client comfortable, but no more.

I’d urge you to read this paper carefully.  Maybe your conclusions will be different than mine.  But my take-away is this: Over the course of an investing lifetime, it is very important to stay focused on growth.

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The S&P Has a Habit of Bouncing Back

November 8, 2012

As much as investors appear to dislike stocks right now, Bob Carey of First Trust points out that the S&P has a habit of bouncing back.  The gist of his argument is contained in a nice graphic and a few paragraphs of commentary.  Here’s the relevant chart:

Source: Bob Carey, First Trust   (click on image to enlarge)

Although this picture is probably worth a thousand words too, his commentary is especially on point.  Here’s what you are looking at:

  • The time periods featured in the chart depict the annualized returns for the S&P 500 from the index’s lowest price point following a crisis situation.
  • Those crisis situations were as follows: 1973-74 (Oil Embargo); 1981 (Hyperinflation); 1987 (Crash/Black Monday); 1990 (S&L Failures/LBOs); 2002 (Internet Bubble Burst); and 2008 (Subprime/Financial Crisis).

Amazing, isn’t it?  If you had the nerve to buy during each crisis, you racked up big returns over the long run.  (The recent returns have been exceptionally strong, but the time period is much shorter and hasn’t had time to include any additional bear markets.)

I find it extraordinary that the market managed 8% annual returns if you bought after the tech wreck in 2002, even after holding it all the way through the most recent financial crisis.  American business is remarkably resilient and our financial markets reflect that.  Even at the depths of a crisis—especially at the depths of a crisis—it makes sense of buy shares in growing businesses.  Headlines and negative investor sentiment shouldn’t necessarily deter you from buying productive assets.

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Stock Market Perception vs. Reality

September 21, 2012

It’s no secret that investors have had a fairly negative outlook toward the stock market lately.  Their negative perception shows up both in flow of funds data and in our own advisor survey of investor sentiment.

One possible—and shocking—reason for the negative sentiment may be that the public thinks the stock market has been going down!

Investment News profiled recent research done by Franklin Templeton Funds.  Here is the appropriate clip, which is just stunning to me:

One surprising finding shows that investors are likely so consumed by the negative economic news, including high unemployment and the weak housing market, that they haven’t even noticed the strength of the stock market.

For example, when 1,000 investors were asked whether they thought the S&P was up or down during each of the past three years, 66% thought it was down in 2009, 48% thought it was down in 2010, and 53% thought it was down last year.

In fact, the S&P gained 26.5% in 2009, 15.1% in 2010, and 2.1% last year.

That blows me away.  I have never seen a clearer case of the distinction between perception and reality.  This data shows clearly that many investors act on their perceptions—that the market has been declining for years—not the reality, which has been a choppy but steadily rising market.

The stock market is ahead again year-to-date and money is continuing to flow out of equity mutual funds.  I understand that the market is scary sometimes and difficult always, but really?  It amazes me that so many investors think the stock market has been dropping when it has actually been going up.  Of course, perhaps investors’ aggregate investment decisions are more understandable when it becomes clear that only a minority of them are in touch with reality!

Advisors obviously have a lot of work to do with anxious clients.  The stock market historically has been one of the best growth vehicles for investors, but it won’t do them any good if they choose to stay away.  Some of the investor anxiety might be lessened if advisors stick with a systematic investment process using relative strength—and least that way, the client is assured that money will only be moved toward the strongest assets.  If stocks really do have a long bear market, as is the current perception, clients may be somewhat shielded from it.

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Biggest Source of Demand For Equities: Corporate Buybacks

August 16, 2012

How is it that the equity markets are moving higher when retail investors continue to pull money out of domestic equity mutual funds ($76 billion in redemptions YTD)?  According to David Kostin, chief U.S. equity strategist at Goldman Sachs Group, the biggest demand for equities this year has come from corporate buybacks.  In fact, there have been $250 billion in corporate buybacks so far this year.  See him address this starting at the 8:15 mark.

As a side note, enjoy the disgust that the hosts display when Kostin tells them that he expects the equity markets to return 8% a year in the coming decade!

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Are Equities Dead or Just Resting?

May 29, 2012

CNBC carried an article today, via Financial Times, that talked about how much investors hate stocks.  Some excerpts from the article:

…institutional investors, from pension funds to mutual funds sold directly to the public, have slashed holdings in the past decade. Stocks have not been so far out of favor for half a century. Many declare the “cult of the equity” dead.

Compared with bonds, stocks have not looked so cheap for half a century. During this period, the dividend yield — the amount paid out in dividends per share divided by the share price, a key measure of value — has been lower than the yield paid by bonds (which moves in the opposite direction to prices). In other words, investors were happy to take a lower interest rate from stocks than from bonds, despite their greater volatility, reflecting their confidence that returns from stocks would be higher in the long run.

But now investors want a higher yield from equities. According to Robert Shiller of Yale University, the dividend yield on U.S. stocks is today 1.97 percent — above the 1.72 percent yield on 10-year U.S. Treasury bonds.

Some hope that the cycle is about to turn and that the preconditions for a new cult of the equity will emerge even if it takes time. Few people doubt, however, that the old cult of the equity — which steered long-term savers into loading their portfolios with shares — has died.

Indeed, equities have not been so cheap relative to bonds since 1956, which turned out to be one of the best moments in history to have bought stocks.

In the U.S., inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years.

I swear I’m not making this up.  Side-by-side, the article discusses the death of the equity cult while it mentions that stocks are at the best buying point in 50 years, apparently without irony.  Wow.

Somewhere down the road there will be a catalyst—I have no idea what it will be, but it could be much sooner than most think.  Contrary opinion would suggest that we look closely at the presumption that equities are really dead.  It’s quite possible that stocks, like Monty Python’s Norwegian Blue, are just resting.  When sentiment gets so highly tilted to one side it is worth examining to see if, in fact, the opposite is true.

Are Equities Dead or Just Resting?

 

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The New Death of Equities

May 21, 2012

From AdvisorOne, yet another article about how much investors hate the market these days:

Despite strong U.S. equity market returns in early 2012 that sent the Dow back above 13,000 by the end of February, indications are that many Americans remain investment spectators, reluctant to participate in the equity market rally, a Franklin Templeton global poll has found.

Investor skepticism appears to be tied to the extreme volatility witnessed in 2011, in which the Dow Jones Industrial Average had 104 days of triple-digit swings-representing a significant portion of the 252 total trading days last year. Indeed, when asked about the importance of various market scenarios when deciding to purchase an equity investment, market stability was most frequently identified by U.S. respondents as an important factor.

“The market volatility that has persisted since 2008 is keeping many investors on the sidelines, and their ability to view positive equity market performance constructively has been thwarted by the market ups and downs that are at odds with the stability they are seeking,” John Greer, executive vice president of corporate marketing and advertising at Franklin Templeton Investments, said in a statement. “But the reality is that investors who have been waiting for ‘the right time’ to get back into the equity market have been missing out on the market rally we’ve witnessed over the past few years.”

This is sadly typical of retail investors.  Volatility tends to be greatest at market bottoms, and volatility tends to be what investors most avoid.  As a result, investors often avoid returns as well!

This period strikes me as psychologically reminiscent of the late 1970s, when Business Week famously published a cover announcing the death of equities.  Consider what investors had been through: in the late 1960s, the speculative names had gotten torched.  By 1973-74 even the bluest of the blue chips had gotten ripped.  By the late 1970s, 20% annual corrections were the norm.  The economy was a mess and investors simply opted out.  The Business Week cover just reflected the spirit of the time.

The late 1970s are not so different from now.  The speculative names collapsed in 2000-2002, followed by a bear market in 2008-2009 that got everything.  The last couple of summers have been punctuated by scary 15-20% corrections.  The economy is still a mess.  Psychologically, investors are in the same spot they were when the original cover came out.  Based on fund flows, “anything but stocks” seems to be the battle cry.

Yet, consider how things unfolded subsequently.  Only a few years later both the market and the economy were booming.  (High relative strength stocks began to perform very well several years ahead of the 1982 bottom, by the way.)  The Business Week cover is now famous as a contrary indicator.  It wouldn’t shock me if the current investor disdain for stocks has a similar outcome down the road.

 

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