Investing in a Colder Climate
Adam Seitchik
Published in Institutional Investor International Edition
April 2003
The beginning of the Iraq war brought with it a sharp rally in stocks and a sell-off in bonds. One week before the breakout of war, the Brent oil price was $34 per barrel; two days into the coalition invasion, the price had plunged $9, and the deeply oversold Dutch, French and German stock markets bounced more than 20 percent in just seven trading days. This phenomenal rally, albeit from deeply oversold levels, represents more than two years of long-term average total return.
Yet no matter what the ultimate outcome is in Iraq, the following negative trends have constrained stock market returns in the past few years and are not going away in the near future:
The painful start to this new century has brought with it a profound change in the investment landscape. Uniquely in the post-war period, an investment bust, not a consumer slowdown, caused the economic recession and stock market correction. Deflationary forces intensified, beginning with the bursting of the Japan bubble in the early 1990s, accelerating during Asian, Russian and Latin American currency devaluations and coming to a head with the recent collapse of technology investment.
If there is any good news in .ill of this, it is that the spectacular overvaluation of equity markets is largely, if not fully, corrected. We believe that the stock market lows of the past nine months will hold, because even the most conservative approach to stock valuation suggests that stocks offer a 3 to 5 percent premium versus bonds in a variety of markets. At the lows in March, markets as diverse as Australia, Italy, Japan and the U.K. had dividend yields equal to or in excess of the local government bond yield. In some countries higher yields for stocks than bonds will limit the amount of forced selling of equities by heavily regulated insurers.
Our belief in the attractiveness of stocks versus bonds in the long run assumes that the world economy will grow modestly over the next decade, without deflation. The risks of deflation are real, but our core view is that the Western world will avoid a Japan-style deflationary trap. Assuming that the normalized growth of the global economy plus inflation will be 4 to 5 percent over the next ten years, stocks with high yields become attractive to economic buyers eager to arbitrage the relative value between real and financial assets. Under positive growth scenarios, stocks offer a healthy premium to bonds, especially when trading down to the lows of the range they have been in since last summer.
Our tactical models suggest that stocks became cheap in the latter part of the first quarter versus corporate bonds for the first time since 1998. However, we do not believe that a tactical trading opportunity marks the beginning of a new, long-term bull market in stocks. The challenges of weakish global growth, mediocre valuations and a more dangerous geopolitical landscape will be with us for some time.
At the beginning of the year, we suggested stocks could rise 5 percent (in Japan) to about 8 to 10 percent (in Europe and North America) this year, and we reiterate those forecasts. Government bonds are well supported by low central bank interest rates, but total return is capped by starting yields of only 4 percent in the West (0.7 percent in Japan). Corporate bonds offer better yield and return prospects than government debt.
The great bull market at the end of the last century was built on very cheap valuations. For 20 years there were no two consecutive calendar years with negative stock market returns. U.S. stock valuations inflated from a trailing price-earnings ratio of 6 all the way to a record P/E of 45 at the end of the tech bubble. U.S. government bond yields in the early 1980s peaked at more than 15 percent and have now come down to about 4 percent. Pessimism was built into asset prices after the stagflation of the 1970s, but the 1980s and 1990s were an era of deregulation, lower inflation and the proliferation of democratic capitalism.
Although excessive valuations have been corrected and we therefore expect long-term positive returns to both stocks and bonds, the bear market will not be followed by an extended bull market, because valuations for stocks have been corrected only to normal, not cheap, levels. For example, despite a 50 percent drop in the Standard & Poor's 500 index, the dividend yield rose to only about 2 percent. The trailing reported P/E ratio is not yet 6, as it was at the beginning of the bull markets in 1950 and 1980 -- it is 28.
At current market levels dividend yield plus dividend (or earnings) growth should create annualized returns to stocks that are attractive relative to bonds in the long run but still below 10 percent on average. Real estate and bonds, even if they continue to offer positive long-term returns as we expect, are nearing the end of what have been phenomenal bull markets.
Investing in benchmarks during the bull market made sense. Stocks, bonds and eventually real estate all soared. As it becomes clear that benchmark returns to stocks and bonds will be not only volatile but much lower on average than in the 1980s and 1990s, the industry is slowly confronting the need for a greater focus on total return and managing short-term volatility.
Thus benchmark investing, the dominant and profitable management style of the bull market, is under serious review. Well-thought-out benchmarks match long-term assets to liabilities, but institutional investors are under pressure to avoid the kind of volatility that leads to punishing, unplanned contributions to under-funded pension plans, or forced selling by insurance companies to manage regulatory surpluses.
A market-directional, benchmark-focused approach may struggle to provide satisfying total returns with acceptable volatility in a rapidly changing environment. For example, a low-active risk, benchmark-relative portfolio doesn't have the flexibility to move sharply away from struggling sectors, countries and stocks.
As the industry confronts the limitations of benchmarks, we expect to see more client interest in concentrated portfolios, long-short structures, overlays and other strategies that allow the investment manager to shift risk away from volatile benchmarks toward attractive investments with good total-return prospects.
Underneath lower-return benchmarks lies ample opportunity. With the U.S. now burdened by large current-account and budget deficits, the world must depend on new sources for growth. The dollar has begun a long-term downtrend. Asia ex-Japan is now 20 percent of global GDP and growing rapidly, representing a promising source of new demand. Since the end of the bull market, resource companies and defensive consumer stocks have outperformed cyclical growth sectors like technology and telecommunications by 60 percent. Ignored sectors such as resources and security may become the new, long-term leadership in this darker era.
There may be other surprising winners in this new investment regime. The trick will be not only identifying these new types of opportunities but having the flexibility to exploit them.