It has been a challenging month for bull market cheerleaders, as renewed tensions in the euro-zone and the growing possibility of a Greek exit, has erased almost all of the current calendar year price gains in global equity markets. Much has been written on the topic, but should the unthinkable happen, it is safe to conclude that the uber bulls will argue that the accompanying carnage was not foreseeable in advance, just as they did following both the demise of the dot.com frenzy in 2001, and more recently, the mind-numbing deflation of the credit bubble.
In truth, the poor stock market performance that accompanied both episodes was not entirely a bolt from the blue, since reliable credit market indicators warned of an impending economic downturn well in advance on each occasion – an outcome that is virtually assured to precipitate a gut-wrenching slide in equity prices.
Meanwhile, and more importantly, the high valuations attached to equity markets at the market peaks registered during the summer of 2000 and the autumn of 2007 respectively, meant that stock prices embodied no margin of safety whatsoever, and as a result, astute investors could reasonably expect a cyclical decline in the major market averages to exceed typical historical experience.
The bottom line is that the actual sequence of events following both market tops was not foreseeable ahead of time, since the future is unknowable, but the potential downside risk implied by the lofty valuations, alongside the warning flags raised by a variety of reliable real-time indicators, gave investors ample time to prepare and adjust asset allocation appropriately.
The idea that the poor stock market returns over the past decade – and more – stems from so-called ‘black swan’ events does not stand up to serious scrutiny. Fundamentals matter of course, but only insofar as they are not reflected in market expectations. Consensus opinion can be discovered in the number of dollars that investors are willing to pay for one dollar of trend earnings, and not in the research reports that the professionals periodically unleash on their clients – and almost always with a bullish tilt.
Successful long-term investing is an exercise that measures probabilities against potential outcomes, but quantifying the likelihood of loss over any time period is hardly an easy task. Nevertheless, it is far from difficult to reach any other conclusion, but the idea that a viable investment process begins – and perhaps even ends – with a plausible estimate of fair value.
The road to superior returns over extended horizons is always a question of value. It may seem unsexy to some, but the verdict of history demonstrates that value matters – and undermines the thesis that so-called ‘black swans’ are to blame for the poor returns generated by the investment professionals since the turn of the new Millennium.
Turn the clock back and the truth is plain to see. The halcyon days of the dot.com boom in the late 1990s saw almost 200 new issues more than double on their first day of trading in 1998 and 1999 as compared with less than 40 over the previous quarter century. The manic nature of the market was captured by former Fed chairman, Paul Volcker, who commented in 1999 that “The fate of the world economy is now totally dependent…. on about 50 stocks, half of which have never reported any earnings.”
The number of dollars that investors were willing to pay for a unit of trend earnings vaulted to more than forty during the spring of 2000 – almost ten dollars more than the peak multiple registered during the autumn of 1929. Absent a pronounced upward shift in the growth rate of trend earnings, the major stock market averages were actually priced to deliver an inferior long-term real return than that available on default-free Treasury inflation-protected securities.
Needless to say, it didn’t take much to precipitate the unwinding of such excess, but more insanity was to follow, as Alan Greenspan re-inflated the asset-based economy. His actions precipitated a dangerous real estate bubble, as the ratio of median prices to median income jumped to three standard deviations above the historic norm.
Meanwhile, investors’ renewed appetite for risk saw stock market values jump to levels by 2007 that were close to the peaks observed at the heights of previous secular market bulls in 1901 and 1966. In other words, stock markets were priced for perfection and provided no margin of safety to withstand any deterioration in the underlying fundamentals.
The near-doubling in stock market averages from the lows registered during the spring of 2009 has pushed valuations back into nosebleed territory once again, with the likelihood that prices decline in real terms over the next ten years increasing to as much as three-in-four based on historical data. Needless to say, a possible Greek euro exit is not reflected in current valuations, and comments that such a development would prove containable, seems eerily similar to the rhetoric that accompanied the sub-prime meltdown.
Risk is running high, as reflected in low expected returns. More astute investors will recognize that successful long-term investment is always a question of value.
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