Lessons of history lost on investment professionals

SERIOUS MONEY:Even a casual glance at data shows the belief that stocks will always deliver returns over long periods is wrong, writes CHARLIE FELL

GEORGE BERNARD SHAW, the Irish playwright and Nobel laureate, penned the four-act drama Man and Supermanin 1903, and in appendix II, he writes: "If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience!" The pages of financial history are replete with examples of dangerous speculative bubbles that seemed to promise untold wealth, only to crash and bankrupt overextended investors.

The cycle of fear and greed has repeated time and again, from the Dutch tulip mania of 1637 to the “Great Crash” of 1929/32 and beyond. The lessons have been lost, however, on investment professionals whose mindset has been shaped by the greatest bull market in American financial history from 1982 to 2000. The extraordinary advance in stock prices during this period saw investors come to believe that stocks always deliver positive real returns over extended periods of 10 years or more.

Even a casual glance at historical data, however, would have revealed that the belief was false. Stock market averages alternate between secular bull and bear market regimes, with the former accounting for all of the real returns generated through two centuries.

The euphoria evident during the spring of 2000 saw investors ignore the warning signals of impending trouble emanating from an inverted yield curve and rising credit spreads. Combined with record-high valuations, that spelled disaster.

A savage bear market did indeed follow and stock prices more than halved by the autumn of 2002. The ferocity of the decline failed to make a lasting impression on investors. Equity weightings remained unduly high as stock prices approached their cyclical peak in 2007 and the lethal cocktail of exorbitant valuations, widening credit spreads and a downward-sloping yield curve was ignored once again.

A mind-numbing drop followed and, despite the breathtaking advance since the spring, the average manager has trailed the inflation bogey by a full 25 percentage points over the past 10 years. Strong stock market performance has seen equity allocations jump to more than 72 per cent once again, but does the verdict of history justify such enthusiasm?

The answer is no. There have been nine previous bear market declines of 40 per cent or more using monthly average prices since 1900: 1901/03, 1906/07, 1916/17, 1919/21, 1929/32, 1937/38, 1938/42, 1973/74 and 2000/02. Share prices advance on average by 25 per cent from the trough during the first three quarters of the cyclical uptick and peak after 21 months for a cumulative increase of 53 per cent.

The current incarnation has seen prices jump by 46 per cent during the first nine months of the cyclical bull, or more than 20 percentage points above average, leaving little room for further gains, before the advance ranks among the largest rebounds in history. Furthermore, the historical average includes the 125 per cent jump in prices off the bottom in 1932; the median gain to the cyclical peak is 42 per cent!

Valuation multiples paint a similar picture. The price multiple on 12-month trailing earnings was 10 times on average at the bottom of the previous nine savage bear markets, and 14 times at the cyclical peak 21 months later. Prices troughed at 18 times 12-month trailing operating earnings during the latest downturn, and are currently trading on 20 times.

A more than 80 per cent increase in corporate profits from the cyclical low to $78 per share – roughly $15 above realistic estimates of long-term earnings power – combined with no increase in stock prices, would be required through the end of 2010 for the trailing multiple to drop to the historical average.

Typically, it takes two to three years from the recessionary trough for corporate profits to surpass long-term earnings power, but such a feat is required by the summer of 2010 simply to justify current prices.

The blistering advance in stock prices off the low in March is also unusual in that it has pushed the price multiple on trend or cyclically-adjusted earnings above the historical average once again. The market troughed on 11 times trend earnings, above the single-digit multiples common at previous lows, but is now almost two multiple points above average and has spent just nine of the past 117 months below average. The overvaluation at 10 to 15 per cent is within historical norms, but stock markets look for any reason to trade at cheap valuations during the latter years of secular bears. Indeed, the price/earnings multiple on trend earnings dropped below 16 times in 1938, bottomed on a single-digit multiple, and did not exceed that level until 1955. Similarly, the multiple fell below its long-term mean in 1973, bottomed at eight times trend earnings and remained below average until 1987.

The jump in the price multiple from 11 to almost 18 times trend earnings since March suggests that investors are confident, not only that a normal V-shaped economic recovery is in the offing, but also that a return to the economic and financial stability that characterised the “Great Moderation” is assured.

The verdict of history is clear and suggests not only that this is wishful thinking, but also that the cyclical rebound will end towards the end of 2010. Further liquidity-driven increases in prices should be used as an opportunity to reduce unjustifiably high exposures.