Are equities finished?

During his formative years in the industry, this writer was constantly assailed with the ‘investment fact’ that over any ten-year rolling period equities outperformed bonds, and bonds outperformed cash. This was the received wisdom even though these years occurred so long ago that it was prior to the onset of the late, lamented Great Equity Bull Market of 1982-2007 (The Great Equity Bull Market saw a price appreciation of over 1,250%, which compounded at approximately 13.5% pa with dividends added. At the same time, bonds experienced a major bull market with ten-year US Treasury yields dropping from around 16% to recent lows at 1.7%.). It is therefore no doubt poignant to many to note that recently the 30-year total return on US Treasuries exceeded that of the S&P 500.

Does that mean that the cult of equity is over? Certainly the cult may be, but it is highly improbable that equities are finished. It should not be forgotten that equities are a key component of the capital structure and, as such, they will persist. In addition, intuitively we believe that no asset class is likely to continue to outperform indefinitely, as it would continue to attract capital to the point that the return on that capital would decline. Empirical evidence confirms that super cycles do exist – but they all end eventually. Finally, the current experience is not unprecedented, as we have seen similar periods previously in history, notably 1907-1921, 1929-1942 and 1966-1982.

Timing the new bull market. Assuming that the current bear market for most indices started in 2000, if the average of the previous experiences is to be repeated then the current environment should be ending around 2014. While this may sound depressing from 2011, we hasten to add that we are not expecting the ongoing bear market to result in continued downside, but rather in the persistence of broad range-trading prior to a sustained breakout to the upside. We note that since 2000 the average for the S&P 500 is close to 1200 (not far from today’s levels), so the market is not extended on a price level nor is it challenged by the vast majority of valuation measures. Note that a P/E multiple of 16x is consistent with the current levels of inflation, and that a multiple of 16x with the S&P at 1200 implies earnings of USD 75, which is certainly not unrealistic. While we are not forecasting a P/E of 16x, we believe that an ongoing low inflation environment may lead to multiple expansion in coming years that will allow equities to drift toward the upper end of recent ranges – once we are past the current malaise

Which leads to another of the received wisdoms: that bull markets climb a wall of worry. At present, the wall appears to be very much in evidence while providing very little opportunity for ascent, notably in Europe, but not exclusively so. As a result, it is not surprising that anecdotal evidence suggests the majority of investors are light of risk, meaning that the pain trade (the development that would cause the most pain to the most people) would be a sharp rally in risk assets. Again, this is not our forecast, but as a thought experiment we look below for any evidence that markets may be surprised