SERIOUS MONEY:Efforts by investment managers have centred on erroneous prospective returns, writes Charlie Fell
THE SAVAGE decline in stock prices since autumn 2007 has plunged most defined-benefit pension schemes into deficit and has pushed some to the edge of extinction.
The investment professionals have been paid well to manage the monies of such beleaguered schemes but have sidestepped much of the blame, partially on the back of assertions that the drop in valuations to ridiculously cheap levels is unprecedented and therefore unforeseeable.
Such claims are not supported by historical fact and are being made by the very same people who have walked blindly into a severe bear market, not once, but twice, in the past eight years.
The words of Karl Marx seem appropriate for the supposed bastions of capitalism when he wrote: "History repeats itself, first as tragedy, second as farce."
Certain investment managers appear to believe that stock markets follow an almost relentless path upward, with occasional downward blips along the way. Nothing could be further from the truth. In reality, stock markets alternate between extended bull or bear market regimes.
The primary determinant of performance during these alternating states of the world is the trend in the price that investors are willing to pay for the market's normalised earnings.
The current secular bear market began during spring 2000 and is the fourth such cycle since the early years of the 20th century.
The behaviour of stock prices over the past eight years has closely followed the pattern apparent during the previous three extended downturns.
The historical data illustrates that the initial cyclical bear market following the demise of a primary bull cycle is always severe, with historical examples including a 49 per cent decline from 1906-1907, 89 per cent from 1929-1932, and 36 per cent from 1968-1970. It is clear that the halving of stock prices from 2000-2002 is of similar magnitude to its predecessors.
The lesson of history, unfortunately, is that investors fail to appreciate that the secular bull market has come to an end and continue to believe that equities are the only game in town. A miniature version of the last hurrah of the secular bull follows, which typically persists from two to five years.
Unfortunately, the so-called "echo bubble" in stock prices means that much of the valuation excesses built-up during the heady days of the secular bull remain and a further sharp fall in prices is inevitable. Such echo bubbles occurred from 1907-1909, 1932-1937, 1970-1973 and again from 2002-2007.
It should be noted that Nobel prizewinner Vernon Smith has recorded exactly the same behaviour in controlled experiments as just described.
Smith has shown that participants in a market which is fully aware of the value of the traded asset consistently produce a bubble and a subsequent crash but, contrary to what might be expected, a further bubble, though smaller in magnitude, is generated by the same players upon returning for a second session.
One interesting finding in Smith's work is that the participants are aware that the pricing structure is irrational as the echo bubble develops during the second trading session but are confident that they will be able to exit the market before other players. Of course, this proves self-defeating as the simultaneous exit by many participants causes the price to collapse.
This particular feature of echo bubbles would not appear to apply to our own investment professionals in the past year. The equity allocations maintained throughout the current cyclical bear have been consistently high and there has been little evidence of selling throughout.
Indeed, reduced exposure seems to be a function of declining prices while increased cash weightings are nothing more than a product of regular pension fund contributions that have not as yet been invested.
The potential improvement in risk/return profile of funds was lost as diversification efforts by investment managers centred on erroneous prospective returns as opposed to a focus on potential risk reduction.
Exposure to energy, commodities, precious metals and high-growth themes, including alternative energy and other eco-friendly ideas, have all been achieved through further concentration in stocks, when funds spread across asset classes - including commodity futures, physical gold, forestry and high- quality corporate bonds - could easily have achieved a more attractive risk/return profile while attaining the desired exposure to attractive themes.
The continued love affair of investment managers with stocks has had a devastating impact on long-term performance numbers such that they have now even failed to match inflation over the past 10 years. Misguided beliefs regarding the merit of stocks alongside questionable diversification efforts are major culprits as, too, is the use of dubious valuation tools.
Investment managers must learn from their mistakes and heed the words of Sir John Templeton: "It is impossible to produce a superior performance unless you do something different from the majority."
Stocks are not the only game in town.
charliefell@sequoia.ie
