The Lost Decade
I’ve written about “the lost decade” before at RealMoney. A lost decade is where the stock market goes nowhere, or loses money for ten years. My purpose in doing so was to point out:
- That it is normal for lost decades to occur. Stock returns are weakly autocorrelated. Good years tend to be followed by good years, and bad years by bad years.
- Once a generation, you have to get a severe boom and a severe bust. It is partly driven by monetary policy/financial regulation laxity, followed by tightness. It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
- This has a chilling effect on retirement planning. Recall my recent article on longevity risk. In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.
I’ll amplify the last point, because the WSJ doesn’t do much with it. Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment). Same for an individual financial plan. If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%. The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.
As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track. Oops, wait. This is America. We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs. Only our corporations save on net.
So, what to do?
- Save more.
- Don’t materially increase or decrease allocations to stocks. Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
- Avoid investing in companies with large pension funding deficits.
- Avoid investments with high embedded leverage, whether individual companies, or ETFs.
- Be wary of investing in esoteric asset classes this late in the performance cycle. They may do well for a while longer, but their time is running out. (It could be one year or another decade.)
- Be ready for increasing inflation. Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
- To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.
Of course, you could be a good stock picker, but that’s not a common gift. The choices are hard when we have a “lost decade.” There’s no silver bullet; only ways to mitigate the pain.
March 26th, 20088:25 pm at
“Don’t materially increase or decrease allocations to stocks. Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.”
How close are we to working out the excesses? (personally I am not sure, but the LEH and GS earnings did not have the predicted write downs). Will the market anticipate the solution? (I don’t know, but it usually does.)
Is this the same advice you would have given at the top of the market in 2000? What about in 1982? Personally, I make my decisions and advise clients based upon the attractiveness of various asset classes and also of particular stocks.
I agree that the length of time cited is not a good reason to buy stocks. Nor is it a good reason to refrain from buying stocks.
Valuation, anyone?
March 27th, 20087:32 am at
Jeff,
I think the issue of valuation is dramatically over complicated by most. I think that projecting a range of likely long term returns can be done using a variety of assumptions. First, assume that nominal GDP and hence profits will grow 6% per annum about the 100 year average. Second, assume that the terminal valuation is based on normalized profit margins. Surely margins oscillate around the long term median/mean, but they are inherently mean reverting. The big variable is the terminal earnings multiple to be used on normalized profit margins.
This is where a range can be used to look at risk/reward. For example, presently I would say that assuming the high end of the historical multiple range, 7-10 year SPX total returns would be in the 6-8% range – essentially earnings growth plus dividend yield. Givent this is a “great” case assumption, I believe the risk/reward is very poor.
Over the past 100 years, the terminal valuation of every long term bear market has been a P/E of under 10. Using that pessimistic assumption would result in negative annualized nominal returns over a 7-10 year period.
The middle of the bell curve would result in very low single digit annual nominal returns for the SPX assuming average profit margins and average valuations on earnings assuing 6% nominal annual profit growth.
John Hussman of the Hussman Funds and Jeremy Grantham of GMO have both written extensively about this kind of long term valuation analysis. It does little in predicting 3-5 year returns but has been quite robust in predicting 7+ year returns. The great outlier in the historical forecasting was the 7+ year periods ending in the late 1990’s given the truly epic overvaluation of the terminal period – i.e. 40x’s+ earnings.
Grantham has stated that long term fair value of the SPX is around 900 which is easy to get to using normalized margins and average P/E or long term average P/S ratios. While the future is never certain, it seems to me that the deck remains stacked against buy and hold US-centric investors.
March 27th, 200811:13 pm at
James -
Since many of us have written extensively on valuation issues, I will not go into detail. You can check out my blog for my take, David’s work on the Fed model, or CXO Advisory.
Whatever method you choose, it should highlight the extremes. Anyone who does not consider interest rates, IMHO, is missing the point of consideration of alternative assets. I never expect to see a single-digit P/E ratio on the S&P — never. Maybe I am older than you.
Basically, it only happens when interest rates are really high, like when I bought my second house. There are also plenty of issues with using trailing earnings from the ‘dead ball’ era to predict what is happening now.
While David and I did not agree on some points, his analysis on this was excellent and worth revisiting.
March 28th, 20088:47 am at
Jeff
Thank you for the thoughtful response – you are always a real pleasure to engage in a debate.
Based on Robert Shiller’s P/E data using trailing average 10 year earnings, the SPX (and his assumed version predating its creation) spent 25 YEARS of the 20th century with a P/E under 10! This suggests that such a valuation has hardly been some kind of crazy extreme but perhaps a natural market condition.
I would certainly concede that such a valuation is cheap and offers tremendous long term investment potential, but to argue that valuations could not become very low and stay low for an extended period of time ignores market history in the US and around the world. Interest rates are certainly a huge factor, but not the only one. The market traded for under a 10 P/E for 9 straight years during a relatively low interest rate environment and booming disinflationary period of economic growth from 1917-1926.
Now of COURSE things are different now than then, but the laws of economics and the role that aggregate investor risk preferences play are not. All of us smart finance guys can run all kinds of models that would argue that such an extended period of cheap stocks doesn’t make sense given low interest rates – but it happened anyway.
So I would argue that your statement that low valuations only occur when interest rates are high is empirically false. Also, as for using earnings from different periods to predict what is/will happen, this is why I think the P/S ratio is key. Accounting standards/gimicks change over time, but profit margins and sales are at the core of profitability and hence valuation.
I agree that analysis of relative asset classes is important but it leaves one vulnerable to one key problem – what if many of the assets being used for comparison purposes are ALL expensive when using absolute valuation metrics for them individually? That is the Mac Truck-sized hole in all of the relative valuation arguments I see currently. The bond market has historically been horribly wrong for extended periods. The early 70’s it underpriced future inflation for years and in the 80’s it overpriced future inflation for years. With even the govt’s CPI data prior to the Boskin fiasco indicating price inflation at high single digits, one must wonder why someone would buy a 30 year treasury at 4.35 or a corporate at a “high” spread of 7%? Sure, stocks seem reasonably valued using those interest rates, but there is a clear argument that those interest rates are way too low and at risk of adjusting significantly higher over time.
March 28th, 20082:50 pm at
James,
Excellent points all around. Not to mention the interest rate factor is somewhat of a red herring. Let us assume that we can call stocks cheap based on relative yields to bonds. Cheap being defined as reasonable, since we certainly cannot call them cheap compared to 1982 or other low periods.
Even if we do that, that only means we see no lower termination P/E multiple. The returns are still low. The 6% nominal rate, plus dividend yield still comes to less than 8% in that case. Since that 6% nominal rate includes inflation of over 4% you get real returns of less than 2%. If inflation is lower (which some will argue it will be relative to the full time period the 6% figure is derived from) that would likely mean lower nominal earnings growth, so the actual real return doesn’t change much. Of course, since interest rates today say nothing of how relatively cheap stocks will be in the future that is an enormous risk for a skinny risk premium.
Which of course shows why the returns are likely to be worse. Because at the end of such a period one would still be facing the same low returns. it would be neverending. Markets are never that stable, and the likelihood is that extended periods of low returns would lead to every setback experiencing lower valuation lows and decreasing multiples as people decide the risk makes no sense at such low return levels. When most people feel that way, and valuations are at depressed levels a real bull market can begin. Likely lasting, with relatively shallow corrections, for a couple of decades.
As your explanation shows, the math tells us we will have at minimum below average returns from here whatever interest rates are. Math and history pretty much leave that baked into the cake. The real question should be how low. My guess is that they are in real terms going to be negative over the next seven to ten years, but nominally positive. I felt that way starting in 1998, and so far nothing has empirically changed the long term relationship between low dividend yields, long run earnings average and the return one is likely to get.
In fact it is worse, because that long term 6% depends on when you measure it. That number only applies at peak earnings. At other times it is substantially worse. If one looks at the range of earnings outcomes long term, the mean of the averages if you will, the number is even less impressive. Given the record profit margins you mention, that would be a more reasonable assumption. Which means earnings growth of only about 1% above inflation from this to any particular termination date in the future. A lower rate is quite possible (from the mid sixties to 2002 the real rate of growth in earnings was negative I believe, showing the time period sensitivity of earnings growth rates.)
Finally your point about other assets now being expensive as well is quite important. Our firm has felt this environment is far more treacherous for the more sophisticated investor than 2000. That was easy. Own anything but overpriced large caps and tech stocks and you did just great over the last eight years. Of course, the problem is that large caps have come down, but are still at historically challenging levels, as you have pointed out. Meanwhile, everything else has appreciated dramatically. The peaks in the valuation landscape may be lower, but the field of battle is far more dominated by mountains in general.