In August of 1978, the bear market that had started in 1968 was already ten years old. Inflation was rising, as were interest rates. Equities were basically unchanged in price for a decade (sound familiar?) and without dividends, there were no gains.
If inflation and management fees were factored in, “real returns” were negative – which is why when you listen to older boomers talk about equity returns since 1999, they can honestly say “been there, done that.”
Business week published a front page article entitled “The Death of Equities,” essentially stating that stocks could no longer be counted on to build assets for retirement or create wealth in the long term.
For the next two years or so, they were right; and then The Great Bull Market of the 1980’s and 1990’s began.
Investors who chose to ignore Newsweek’s advice enjoyed a compound rate of return of just under 18% per year from 1978 to 1999 (enough to allow $100,000 to grow to $3.1-million with dividends reinvested).
As they say with respect to comedy: timing is everything.
Are Equities Dead?
Recently, a number of well-respected analysts and investment managers have stated for the record that the “cult of equities” is dead.
People such as Bill Gross, CEO of PIMCO, the world’s largest fixed income investment manager (pictured above), David Rosenberg of Gluskin Sheff, and Ed Easterling of Crestmont Research are suggesting returns for the next decade or longer will be no better than they have been since 1999.
Just as a reminder (as if you needed it) equity returns in the last twelve years have been dismal (especially if one adjusts for both inflation and transaction costs). The chart below says it all.
In fact returns are worse for Canadians, because while the TSX had a reasonable result of just over 3% per year after fees (assuming annual fees are 1%) and inflation for the last twelve years, foreign markets performed poorly.
Much of that was due to a relatively strong dollar that has appreciated about 50% against the U.S. dollar in that time frame.
As we have written several times in the past, we believe that we have been in a secular bear market since the end of 1999 and that, on average, these markets last about 17 years.
This one is already 12 ½ years old, yet many are now predicting that, as an asset class, equity’s days as a contributor to one’s long-term wealth are over and that this secular bear market could last a generation from this point forward.
Are they right? I suppose we’ll know the answer to that with certainty in about twenty years.
As our clients know, we have recommended that portfolios need to be well-diversified and own assets that generate cash flow. Our ideal balanced portfolio model suggests a weighting for equities that is approximately 30%.
We are not market timers, but we do believe in active management of the equities we want to own and we continue to use cash flow strategies such as covered writing to enhance returns in this secular bear market.
At some point, however, this market will end. Is it going to be another ten to twenty years as suggested by people such as Bill Gross? For now let’s examine the arguments that support their claim and those that contradict them.
For the record, I would like to state that I am no apologist for the buy and hold camp of equity investors, but I certainly feel equities are an important asset class and there are many companies I am happy to have an ownership stake in.
The Cases For and Against Equities
First we should note that most of the analysis below relates to U.S. equities, but we are highly correlated to that market, save for our high dependence on resources.
The following arguments have been made by several financial pundits who are calling for equities’ death knell. With each argument against, we will provide a counter-response for equities and look to shed some light on reasons why this asset class is either a viable option or simply misunderstood.
1: The stock market is high as a percentage of GDP.
One measure of overall market price compares the value of all publicly traded equities in the U.S. to U.S. GDP (gross domestic product). Over the last 100 years, that has been about 60%. It peaked at 180% in March of 2000 and then dropped to 61% in the spring of 2009. It has since increased to 100% of GDP and is therefore relatively expensive by this standard.
As I look at this measure, I have wondered why there should be much of a correlation between GDP and the value of U.S. equities. Over the last 50 years in particular, many major U.S. companies receive a significant portion of their revenue from overseas (think of Coke, Google, Pfizer, Microsoft, Ford, etc.).
Why, then, should either their price or their profits be connected to U.S. GDP? (Especially if the markets they are earning new revenue in are growing faster than the U.S.)
Source: Bianco Research
2: Price/ Earnings (P/E) ratios are well above what they typically drop to at the end of secular bear markets.
Based on 2012 expected earnings, the S& P 500 is trading at a P/E of 13.2 (as of August 9, 2012). When the 1968-1981 secular bear market ended, P/E ratios were 8. The market would have to drop by about 50% to get to that level today (that would put the S&P at about 650).
The counter-argument to this is that in 1981 we were experiencing 10-year bond rates that were well over 12%, and for equities to be attractive, they would need to provide relatively high dividend yields (the S& P 500 paid a dividend yield of 5.4% in 1981 [currently about 2.2%]).
High dividend yields usually require relatively low P/E ratios. Today, stocks are competing with 10-year bond rates that are well under 2%. The dividend yield of the S&P 500 is higher than 10-year bond rates (it has been since 2009) and the last time that occurred was 1957 (see chart below, “Back to the Future”).
Even if stocks are expensive, they certainly seem to be offering better value than government bonds.
Furthermore, companies are holding on to their cash. Unfortunately, it is often misused, buying back shares (which also helps the value of executives’ stock option programs) and to acquire companies which often end up integrating poorly with the parent.
The percentage of earnings being used to pay dividends has dropped to record lows (see chart below, “Dwindling Dividends”). On average, since the 1930’s, companies have paid about 55% of their earnings to shareholders as dividends.
Today it is just under 30%. Despite that, the current dividend yield is almost 50% higher than the ten year bond rate.
If companies reverted back to a 50% payout, the dividend yield would be about 4% – or more than double that of ten year bonds. Over time, it has been shown that the total return one earns from equities is highly dependent on dividends (cash flow).
It is time for these companies to spread the wealth and if they feel they can redeploy shareholder capital better, then the shareholders can show their support by using a DRIP (Dividend Re-investment Plan).
3: Long-term returns of stocks have far exceeded real GDP growth, and that is not a sustainable model.
Bill Gross makes several arguments to suggest that past equity returns are unsustainable and, in his words, represent a Ponzi scheme.
Why does he say this? It is because in his analysis the inflation-adjusted returns of equities for the last 100 years have been 6.6%/yr., but the real growth in the economy has only been about 3.5% annually. Therefore, the stock market has grown far faster than the economy and that, by definition, is unsustainable.
If this were true we would agree with Mr. Gross, but it appears he has made an error in his math: he has included the impact of dividends in his total return calculations.
If he simply uses the value of the stock market, he will see that the price of equity markets has risen in real terms at about 3%/yr. So slightly less than the growth in GDP, much as one would expect. I have to say I am little surprised that he would make such a basic misstep in analyzing returns.
He also notes that over the last fifty years labour has been getting less of the economic pie while capital has been getting more, and eventually that will have to change (see chart below, “Capital Trumps Labor”).
I might agree somewhat more with this argument, but I also wonder if this is nothing more than the impact of an aging population where retired people do live off the earnings of their capital. If society as a whole becomes wealthier and older, then one might expect a larger percentage of their income to be derived from rents, dividends, and interest, and less from labour.
4: U.S. companies profit as a share of U.S. GDP is well above long-term averages and will eventually revert to the mean (shrink in terms of profit as a percentage of GDP).
I recently read a very good book by Ed Easterling entitled “Probable Outcomes.” It was written in 2010, but he has updated some of his material in a recent column published by John Mauldin.
The chart below (“Pre-Tax Corporate Profits As % of GDP”) is an interesting one, because it shows that U.S. companies’ profits as a share of GDP are near all-time highs and well over the long-term average of just over 9%. This seems to be a mean-reverting statistic and over time should regress to the average or below.
Nevertheless, it still raises a question in my mind: compared to the past, how much of the earnings on U.S. companies are a function of their foreign sales and, as such, should not be measured against U.S. GDP?
If Easterling is right, then one would expect earnings for U.S. companies to hit some strong headwinds as stock prices to struggle to appreciate. Easterling expects there to be little, if any, price appreciation in equities for the next decade.
A Long Way To Go
In many ways, it is hard to argue with the data above that suggests we have a long way to go before this bear market in equities is over, but, as with most things, we sometimes need perspective.
One definition of perspective is “the faculty to see all relevant data in a meaningful relationship” (as in “your data is admirably detailed, but bit lacks perspective”).
I hope I have provided some strong evidence to be concerned about future equity performance and at the same time some perspective about being an investor in this environment. Let me finish with the following observations.
- When we invest in equity markets on your behalf, we are buying companies. We are not buying the market. In this long-term secular bear market we are comfortable that this makes a difference.
- As many of you know, we use covered calls to try and reduce the volatility of the markets and increase cash flow. Over the last five years, that approach has allowed our NWM Strategic income Fund to outperform the S&P/TSX Composite by almost 3%/yr. after costs.
- The last bear market lasted from about 1968 to 1981. While stock prices did not rise and were negative after fees and inflation, dividends were paid and, over that thirteen years, grew by 125%. As an example, an investor with $100,000 invested in the S& P 500 in 1968 earned about $3,000 in dividends (3%). By 1981, that annual dividend had increased $6,750/yr. even though the portfolio was still only worth just a little over $120,000 (less than $100,000 in 1968$). The same has occurred over the last twelve years. The S&P 500 is still below where it was at the peak in 2000, but dividends have doubled (and they would be much higher if companies were paying out the 50% of earnings to shareholders as dividends they did in the 1990’s).
- Economic growth over the next number of years in developed countries will likely be well below historic levels as they grapple with a combination of government debt and demographics, but that does not mean that great companies with good growth prospects will cease to exist or that opportunities for returns will not present themselves in other parts of the world.
We are not blind “buy and hold” equity investors. We believe in active investing, cash flow generating assets, and diversification. We certainly expect the next number of years to be subpar for passive equity investing, so we will keep our overall allocation to about 30% and continue with cash flowing strategies.
However, that is not the same as suggesting that the cult of equities is over or that their death is imminent. There are a lot of people on that bandwagon, and at some point it will be time to get off.
This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as personalized investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Statements concerning financial market trends are based on current market conditions, which will fluctuate.