A few weeks ago I met with the investment committee of a not-for-profit client for which I do consulting work. Membership on the committee has changed over the years, but the organization characterizes itself as unable to sustain any appreciable level of loss, regardless of market behavior. As a result, committee members have chosen to hold a relatively small permanent allocation to equities. Most notably when there is committee turnover, there has been a tendency to revisit the question of equity exposure. In 2007, after four years of stock market rally, the committee was eager to increase the permanent equity exposure. By the second half of 2008, they wanted to explore reducing it. After the current rally that began in 2009, the committee is once again evaluating possible increased exposure. The following material is a portion of the report I prepared for their review before our most recent meeting. The contents are worthy of consideration by both individual and institutional investors, many of whom may feel tempted to ramp up their equity risk exposure.
Momentum: Stock prices have been rising in the U.S. and in most of the world for more than four years.
Central Bank Support: Our Federal Reserve and about 40 central banks around the world have been providing unprecedented stimulus. Several have acknowledged that, among other objectives, they are aggressively attempting to boost stock prices. A number of central banks have admitted to purchasing stocks directly. I suspect that many more central banks are also buying, either directly or through surrogates.
Corporate Earnings: Although growing slowly, earnings are at all-time highs.
Interest Rates: While rates have risen from their lows set a year ago, they still remain near historic lows.
At the end of the 1990s we counseled clients about the imminent inception of a long weak stock market cycle, similar to those that had unfolded with regularity over the past two centuries. Such cycles have served the purpose of expunging excesses of the prior long strong cycle. While differing in length, long weak cycles have averaged about a decade and a half and have ended only with stock valuations at rock bottom levels, with investors having a substantial and durable distaste for equity ownership. The proximate causes for the inception of this weak cycle were stock valuations far above any past levels, and debt relative to Gross Domestic Product exceeded only in periods of war.
The most recent long weak cycle began in 2000, with stock prices declining by about 50% through March 2003, despite aggressive Fed monetary stimulus. Fed rescue efforts ultimately led to a major stock market and housing rally, which culminated in the mid-decade housing bubble. Both stock and housing prices collapsed in the ensuing crisis. Debt excesses were so severe that the world financial system nearly froze in 2008 until central bankers agreed to support the obligations of most major financial firms. That rescue effort continues through today with whole countries now needing central bank support to avoid debt defaults and bankruptcy. So far, at least in the United States , investors have trusted that central banks will continue to ward off significant stock market declines.
Debt Levels: Unprecedented rescue efforts have led to historic debt throughout most of the world’s developed economies. An increasing number of countries are reaching levels of debt relative to GDP that have precipitated financial crises and defaults over past decades and centuries. The United States cannot possibly meet all of its financial obligations, including social security and Medicare promises. How it will eliminate some of those burdens is unknown. Below the federal level, the recent city of Detroit bankruptcy announcement is likely the first of many city failures. How unpayable state obligations will ultimately be resolved is similarly unknown.
Valuations: While far below the bubble level valuations that prevailed in the late-1990s and well into the following decade, today’s stock valuations are still extremely high. Price-to-earnings ratios are above the long-term average, but are not extreme. Price-to-dividends, book value, sales and cash flow, however, are at or near all-time highs except for the recent bubble period.
Unemployment: Despite nearly five years of unprecedented stimulus, unemployment remains far above average, and many have left the workforce after lengthy, unsuccessful job searches.
Growth Slowing: After a severe recession, Europe has just barely produced one quarter of mild growth; the U.S. is growing below what has in the past been considered “stall speed”; emerging nations–especially China–are experiencing much slower growth than forecast; the International Monetary Fund has repeatedly dropped its forecast for world growth.
Implications for Investors
Committee members should evaluate current world economic and market conditions carefully before making any change in risk assumption. Dramatic negative surprises could occur very quickly in the current environment. When a country default might realistically be announced overnight with potential bank failure fall-out, permanent equity positions could be hit very hard. Should Germany ultimately decide not to underwrite much of Southern Europe, market reactions could be violent. These are not traditional concerns like those preceeding possible recessions. The potential is very real that a country might be allowed to default, and world confidence in the stability of affected central banks would be tested. Permanent equity positions would, of course, be exposed. The committee must decide whether the assumption of that type of non-traditional risk is appropriate.
Given the very clear worldwide correlation between recent stock market progress and prospects for continued central bank stimulus, adding permanent equity exposure constitutes a bet that experimental monetary policies will ultimately succeed in overcoming problems brought on by excessive debt. While that outcome is possible, many centuries of history argue against it. Hundreds of worldwide debt-related financial crises over the past eight centuries demonstrate many similarities, although the specifics of each may differ. Almost all of them led to prolonged economic disruptions (one to two decades), notwithstanding aggressive government rescue efforts. While deflation certainly occurred as part of many of the episodes, profligate money printing (as characterizes the current debt crisis), more often than not ultimately resulted in substantial inflation. It is unknowable how the current episode will end or when. We remain in a high-risk environment.