Longer bears not as hard to spot as some might say

SERIOUS MONEY:Stocks have delivered the highest returns through time because they are high-risk assets, writes Charlie Fell 

STOCK MARKET turbulence persisted through November as share prices fell through the lows seen in 2002 to levels in real terms first registered during the spring of 1995.

The idea that stock markets entered a secular bear market (a bear market lasting several years) during the year 2000 is no longer a matter of academic curiosity but a harsh reality, as all of the returns generated during the cyclical upturn have been more than erased while the long-term numbers illustrate that stocks have lagged default-free treasury bonds over the past 20 years.

The investment industry's failure to spot the telling clues has decimated the funding position of defined-benefit pension schemes.

Investors' mindset appears to have been shaped by the great bull market from 1982 to 2000, which witnessed the greatest increase in total real stock returns in US financial history.

The truths and half-truths accepted by many as conventional wisdom during this extraordinary period means a large number of investors do not have the breadth of experience that they believe they have, but just one, repeated several times over.

The dubious logic that stocks are always the asset of choice over medium- to long-term horizons and the resulting heavy stock allocations in recent years, alongside thematic investment concentrated in equities, is testament to this fact.

The damage inflicted to long-term returns has seen some managers extol the virtues of stocks over longer periods, from 30 to 40 years.

Of course, similar analysis can be used to show that stocks are not a sure thing after all.

Statistics since 1900 show Japanese, French, German and Spanish equity investors would have needed an investment horizon of 50 to 60 years to be assured of a positive real return, while Belgian and Italian investors had to wait more than 70 years.

Irish investors had to linger almost a quarter of a century before stocks broke even in real terms. One should also consider the plight of Argentine investors since 1900 or their Russian counterparts in 1917, all of whom were operating in promising markets at the time.

The verdict of history is that stocks have delivered the highest returns through time simply because they are high-risk assets. Additionally, and perhaps more importantly, stocks do appear to be the safest asset for long-term investors due to their mean-reverting properties.

Mean reversion means that allocations to equity should be lowered following a protracted period of spectacular returns and the record valuation levels that prevailed in the late 1990s, and the low-risk premium for stock investing thereof suggests that future returns were likely to be low for a protracted period.

The price/earnings multiple on trend earnings rose from 15 times in 1995 to an unprecedented 38 times in early 2000. The long-term real returns on offer had dropped to below 3 per cent and were on a par with those available on treasury bonds. An accident was in the making. It was not a matter of if but only a matter of when.

The stock market duly obliged, and a severe bear market followed. However, the valuation excesses built up during the late 1990s were not fully corrected when stock prices bottomed in 2002. The credit-fuelled upturn began on normalised price/earnings multiple of almost 18 times and rose to more than 25 times at last year's peak.

The perma-bulls believed that the severe market from 2000 to 2002 was an aberration and that the good times had returned. They were wrong, as the secular bear struck again and shook the conviction of even the most optimistic. Stock prices have declined by more than 60 per cent in real terms from the high of 2000, in line with the savage drop from the peak in 1968 to the low of 1974 and only 10 percentage points shy of the infamous fall from 1929 to 1938.

The second act of the current secular bear market has erased the valuation excesses of the late 1980s and then some, with the normalised price/earnings multiple dropping below 12 times for the first time in more than two decades. The long-term nominal returns on offer are close to 12 per cent versus treasury bond yields below 4 per cent. The conclusion is inescapable - stocks are now cheap. Secular bear markets are savage affairs, but certainly not as difficult to spot as the investment professionals would have you believe. High valuation levels lead to poor long-term performance, a fact that is validated by statistical significance tests. Active investment managers should have the ability to side-step the worst of secular downturns but, unfortunately, such skill has been sadly lacking during recent years. Questions need to be asked.

charliefell@sequoia.ie