nother decade’s coming to a close brought to mind an essay we wrote for
the
Financial Times in the spring of 2009, near the end of a
very different kind of ten-year period for thefinancial markets and
investors. Entitled “Current valuations reward the long-term view,” it
appeared just a couple of months after the great market crash of 2008-09
had reached its nadir. Ten year returns on equity investments had turned
negative, and an overwhelmingly bearish attitude towards stock
investments reflected the aftermath of the worst market rout since the
Great Depression.
While much of the piece dealt with a debate
between long-term, “buy and hold” investors and those who felt
that short-term trading could save the day when markets turned south, we
always felt the following sentence was of greater significance: “Negative
returns over the course of a decade say more about the price of stocks
ten years ago than they do about the wisdom of buying and holding.”
Ten years prior (in 1999), enthusiastic buyers had paid very high prices
(on average) for stocks. History and simple math indicate that one
should expect poor results under such circumstances, so the negative
figures realized ten years later were not really surprising. We wrote
that given the depressed conditions and attractive valuations prevailing
in early 2009, returns going forward could turn out well, as conditions
were ripe for a rebound. As it turned out, our assessment was correct;
what followed was a long rise in stock prices.
Now, once again, people have a growing faith in
equities, following prices higher. Similar to the earlier period, stocks
are the “only game in town,” but a “reversion-to-the-mean” would seem
likely at some point, as stocks (adjusted for inflation) have returned
approximately 11% annualized since 2009, above long-term averages. By
some measures — the Shiller “CAPE” index
—
for example, valuations are in
extreme ranges as well. Much like 1999, this is not an environment that
bodes well for future equity returns.
What brings us to where we are now was another
year of exceptional gains for U.S. stocks in 2019, with the popular
indexes reaching a series of record highs, ending the year with the best
returns since 2013. Including dividends, returns since 2009
reached 254% for the S&P 500, the most common benchmark used by
investment professionals to gauge movements in the American markets. The
market rise reflects, and likely has contributed to, an economic
expansion that is now the longest on record.
Given the record of the last decade, it is
remarkable that according to the results of a poll released in early
December, two-thirds of Americans feel untouched by the great rise in
aggregate corporate value. Furthermore, they are voting with their
wallets, as record sums have been withdrawn from stock funds this year.
This puzzling contradiction probably relates to the fact that individual
ownership of equities is concentrated among the wealthy. Lesser mortals
tend to have stock exposure through retirement plans investing in
various kinds of equity funds, among other investments, so the direct
impact of changes in equity values may not be as apparent. Positive
consequences of higher stock prices
—
such as a stronger
economy
—
certainly benefit everyone, but the direct connection with the
stock market is muted. Also, in spite of the booming financial markets
and strength in a few areas like technology, reports indicate that
industrial sectors of our economy are experiencing slower growth or even
a mild recession. Changes in the real economy would have a greater
impact on most people’s lives than movements in the Dow Jones Industrial
Average. This factor might explain some of the withdrawals, although
politics and aging Baby Boomers probably played a role as well.
On December 9 we learned with some sadness of
the passing of Paul Volcker, who had presided over the U.S. Federal
Reserve Bank from 1979 until 1987. It was a traumatic period in
financial history, one which we experienced first-hand when we entered
the world of Wall Street in 1982. We have always considered Volcker to
be the true master and hero of central banking during the latter decades
of the twentieth century. Almost single-handedly, and in the face of
much criticism, he used the blunt force of crushingly-high interest
rates to subdue high rates of inflation, and, more importantly, to quash
the expectation that prices would continue to rise rapidly. “Inflationary expectations” had become so firmly entrenched in the
business community and among the public at large that business
investment and consumption were distorted. In dealing forcefully with
these problems, Volcker was blamed for the severe economic contraction
and high levels of unemployment that ensued, but the bitter medicine
worked. Inflation had been running at a 14%annual rate in the spring of
1980; after four years of rates as high as 20% on interbank loans (with
bank CDs offering returns of over 13% for six months), the rate of price
change dropped to 4% in 1984. There followed a long period of declining
interest rates, subdued inflation, and robust economic growth. Lower
inflation and steadily sinking interest rates eventually created their
own problems, however, and in later years Volcker advocated stricter
oversight of banks, and sought to reign in the casino-like behavior that
had taken hold in many financial institutions.
It was with some irony that, on the same day as
the Volcker announcement, there appeared in the
Financial Times
an article discussing steps being taken in some countries, including the
U.S. and E.U., to ease some of the new banking regulations put in
place following the financial crisis. These regulations subjected banks
to tougher capital requirements in order to fortify them against a
future crisis and reduce the incentive to speculate with bank (and,
ultimately, taxpayer) funds. Many in the industry believe that these
restrictions and “capital buffers” are excessive and inhibit
profitability (bankers usually complain about regulations
—
until they need
bailing out), and lobbying campaigns have sought to lift controls. Some
of the new regulations should, perhaps, be reviewed (those impacting
small banks, for example), but in general this seems a bad time to roll
back bank oversight. Prices of financial assets
—
from stocks to real
estate to private companies
—
have been pumped up by low interest rates
and gobs of money flooding the system. Since banks are at the hub of
this activity, and their excesses were key to the crisis a decade ago,
it doesn’t seem wise to reduce their oversight. The “reach for yield” in
the current low-return environment leads to more risktaking, and despite
the regulations, the fundamental incentive schemes for banks
—
which
tend to separate personal interests from institutional probity
—
still
exist.
Over twenty years ago, we penned an
article entitled “What Speculation?” in which we discussed how some
supposedly-conservative mutual funds had been actually engaging in
aggressive activities that were probably not what their customers had in
mind for their savings. It’s happening again, and for the same reason:
an attempt to goose returns to beat rivals for assets in a
highly-competitive market. Although once again the focus is on technology
stocks, in 1999, funds were taking oversized positions in young
companies trading on public market places, whereas now fund managers are
betting on companies before they even enter the public sphere. It has
long been possible for certain “sophisticated” investment operations to
buy shares in start-ups (companies which appear to hold promise though
they may not yet have profits or even revenues). Now mutual funds are
getting into this game, targeting so-called “pre-IPO unicorns.” “Unicorns”
—
a relatively new term
—
typically refers to certain
heavily-hyped private companies with “disruptive” technology offerings
in which early investors expect to make a killing when shares are
eventually sold to the public. Some of the biggest mutual fund companies
have poured billions of dollars into the best-known of the unicorn
concepts.
This practice is objectionable for a couple of
important reasons. First, speculating on new businesses is normally the
province of venture capital or private equity firms whose personnel are
accustomed to evaluating businesses that often have no earnings, and
whose prospects are subject to a high degree of uncertainty. Mutual
funds should have a more conservative orientation, investing in
companies that have a history of earnings, and a “seasoned” public
company status. Aside from the potential mismatch of skills, experience,
and judgement, do mutual fund shareholders really expect their savings
to go into speculative ventures? Probably not.
Secondly, the consequences of error could
inappropriately fall on ordinary individuals putting away money for
retirement or other purposes, and not professionals and institutional
asset managers who presumably understand, and can handle, the risks. As
is usually the case, if such commitments work out, then all is forgiven,
and, in fact, most fund holders probably would be blithely unaware of
what had gone into achieving their results. If things go wrong, then the
funds risk a backlash that would probably reinforce the already strong
trend to indexing. Negative experiences have indeed been piling up. A
botched IPO of one “unicorn” resulted in write-offs of as
much as 75% at some mutual funds; another’s problems led to
valuation cuts of 50%. It could be that these “investments” remain so
small at this time as to limit their impact, but it is not a good sign
that retail funds are once again reaching for return in unusual places.
Speaking of IPOs, the biggest ever came to
market in December when one of the national oil companies among the OPEC
group raised over $25 billion for its state owner by selling shares to
the public. The term “public” should be taken with a grain of salt in
this case, since buyers were limited to local and regional financial
markets, and many of them faced pressure from political authorities to
commit their capital and help the company achieve a targeted market
value of $2 trillion. (A valuation of $1.7 trillion was fixed on the
offering, although it did touch the $2 trillion figure a couple of days
after the shares started trading.) Foreign bankers, including large U.S.
firms, were initially enlisted to sell shares internationally, but when
they failed to drum up enough enthusiasm to back the sought-after $2
trillion value (figures as low as $1.2 trillion were reportedly
discussed), they were ignominiously dismissed, and company and national
leaders then turned to local markets where they could exercise more
influence. In the past we have warned that IPOs are seldom suitable for
investment purposes because they are accompanied by special promotional
efforts on the part of enthusiastic sellers; this deal was a perfect
example. When it comes to IPOs of any sort: buyer beware.
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