It’s the End of the World as We Know It (With Apologies to R.E.M.)
Much of what’s confounding about our wayward financial markets today can be explained, I think, by reference to the chart below. It plots the price level of the S&P 500 from the early 1960s through today.
If you look at the red, upward-sloping line on the chart you’ll see that from late 1974 to late 2007, this trend line captures much of the market’s progress for the 34-year period.
Of course, it’s not point-for-point accurate. The market accelerated at a steeper pitch above the trend line in the mid-1980s. The Crash of 1987, however, brought the market right back to trend.
The stock market didn’t move off trend again until the mid-1990s when the dot-com bubble carried stocks aloft at a very steep pitch to the peak in March of 2000. From there the dot-com bust of 2000–2002 brought the market back to the trendline, which it then followed steadily upward through the end of 2007.
The Old Normal
I find this stability of trend rather uncanny. What’s more, if you calculate the trendline’s pace of ascent, you’ll find it annualizes to 10 percent. That is, for 34 years U.S. stocks rose at an average rate of 10 percent per year (and that doesn’t count dividends).
This, I submit, is – or at least was – the core expectation of the vast majority of investors alive today: an upward-trending stock market, occasionally interrupted by hiccups, with long term gains compounding at double-digit rates. And why not? Three decades of experience had taught us it was so.
This experience and the expectations and attitudes it fostered are what many, ourselves included, now think of as “the Old Normal.”
The Old Normal died in late 2008 with the collapse of Lehman Brothers and the subsequent cascading decline in the stock market. This took stock prices back to the lows made at the depths of the dot-com bust of 2002. It also revealed a rather surprising fact: the U.S. was in a secular bear market that was already nearly eight years old.
Despite an 80 percent rally from March 2009 through April 2010, we’re still in the same secular bear market today, now over ten years old. Officially, the bear market won’t end until we make and sustain new highs above those first reached in 2000.
Back to the Future
Today we find ourselves in a stock market much like the one investors faced from 1968 to 1982 (again, see chart). For 14 years stock prices rose and fell without sustaining a new high. You had some big rallies where stocks doubled, and some big declines where prices fell 50 percent or more. But the net of it all was a sideways market. In September 1982 the market was trading right where it had been in September 1968. Likewise, the market today is trading where it was in the fourth quarter of 1998.
Welcome to the New Normal.
In the New Normal many of the beliefs about investing that had become axiomatic in the Old Normal have been turned on their heads. Beliefs like:
- Stocks deliver higher returns than bonds. For the ten years through the end of August, the S&P 500 returned a negative 31 percent while Treasury bills returned a positive 28 percent. So the low risk asset outpaced the high risk asset.
- Investors should maintain a constant allocation to equities (i.e., no “market timing”). In a sideways market that lasts over a decade, a static allocation to equities that track the general market may well produce flat net stock returns with a lot of volatility along the way – as in the last decade.
- Stock dividends don’t matter since the lion’s share of stock returns comes from price appreciation. While this was true for much of the Old Normal period, during the longer span from 1950 through 2009 dividends represented a third of the total return from stocks. During the sideways market of the late 1960s to the early 1980s, dividends counted for 59 percent of stocks’ total return.
Each of these foundational assumptions made sense in the context of the Old Normal where a rising tide of stock prices could be reliably counted on. No longer.
If anything, negating these principles would have been the formula for success over the past ten years. Stocks show lower returns than bonds. Investors should pursue a dynamic asset allocation strategy for equities, actively taking in and letting out sail (equity exposure) as market conditions dictate. Stock dividends do matter since they provided the only positive cumulative return from equities for the past decade.
Driving by Looking in the Rearview Mirror
So is this our answer to investors who ask how they should respond to the New Normal? Simply put an emphatic “not!” after all the principles that guided successful investing during the Old Normal? Would that it were so easy. What we can say is that these principles must be reconsidered critically.
Clearly they haven’t worked for the past decade. But modeling one’s investment strategy on what did and didn’t work over the past ten years falls under the heading of “driving by looking in the rearview mirror,” and that is not advised. The fact that markets did X over the past ten years doesn’t imply they will do X for the next ten. Nor does it imply they will do the opposite – for example, revert back to the Old Normal.
We must rather be forward looking in formulating a strategy for the next decade. One of the forward looking arguments for a continuation of the New Normal state of affairs has been offered by Bill Gross and Mohamed El-Erian, co-CEOs of PIMCO, the world’s largest bond fund manager. Indeed, it was Gross and El-Erian who popularized the “New Normal” meme to describe the U.S. economy going forward and to distinguish it from the Old Normal period of the 1980s and 1990s.
A Headwind of Deleveraging
The PIMCO argument is that economic growth in the U.S. will be hampered for the next few years by an extended deleveraging process on the part of the U.S. consumer. For more than two decades the U.S. economy enjoyed a tailwind of increasing consumer spending fueled by ever-rising levels of debt on consumers’ balance sheets. For the next few years that process will reverse, creating a headwind for the U.S. economy as consumers pay down debt and spend less. As consumer spending accounts for 70 percent of total U.S. GDP, as the consumer goes, so goes the economy.
While the U.S. stock market’s rate of advance isn’t tied exclusively to the pace of expansion in the U.S. economy, the two are fairly well correlated. If you think the U.S. economy will expand at a subpar pace, you should expect U.S. stocks in aggregate to advance at a slower rate as well.
Should the New Normal economic climate hold for the next few years, this could well lead to a continuation of the “sideways” market we’ve experienced over the past decade. That doesn’t rule out big advances within that overall sideways pattern. Nor does it exclude big declines. But it would mean that investors counting on a steadily rising tide a la the Old Normal will be disappointed.
What To Do?
So what options should investors consider should the New Normal continue? The obvious answer is to seek out return strategies that don’t depend on a steadily rising tide in the U.S. stock market. Here are a few:
- Fixed income investments (bonds), generate a return that doesn’t require price appreciation. While the interest rates paid by high quality bonds are low today, they are positive and reliable. Should the U.S. economy roll over into a “double dip” recession, high quality bonds would also likely appreciate in price, offering a hedge against a slowing economy.
- Dividend paying stocks should also be given higher priority, particularly stocks of high quality companies with strong balance sheets that can support current and possibly rising dividend payouts. It’s one of the peculiarities of the current market that high quality, large capitalization U.S. stocks are rather cheap compared to other segments of the U.S. market. These tend to pay handsome dividends while often having a global reach in their businesses. In a related vein, real estate investment trusts (REITs), utility company stocks and preferred stocks also tend to pay high dividends.
- Perhaps somewhat controversially, we’d have to say that a more dynamic approach to equity allocation is called for in a sideways market. This amounts to tactical market timing in the sense that investors would increase and decrease their equity exposure (let out and take in sail) more actively based upon market and economic conditions. We’re not suggesting that it’s easy to identify the relevant “market and economic conditions” that could guide such a successful strategy. But we believe those conditions would be grouped for the most part under the two headings of “general market valuation” and “the business cycle.” (We’ll expand on this in the next Investing for a Better World.)
- Investors should consider exposure to stocks of firms in economies that aren’t hampered by consumer deleveraging. As virtually the entire developed world is suffering from such deleveraging, this means gaining exposure to emerging economy markets such as China, India, Brazil, South Korea and others. This poses particular difficulties for socially responsible investors as social data on firms in emerging economies is sparse. At Trillium we are in the early stages of researching the best way to address this need for socially screened, emerging market exposure.
- Lastly, absolute return, market neutral equity funds are designed precisely for New Normal, sideways markets. These funds combine long (buying) and short (selling) strategies to neutralize the impact of general market movements on the fund. These strategies are designed to earn their returns regardless of the general market’s action — whether up, down or sideways. While more widely known among institutional investors, absolute return funds are rising on the horizon for individual investors because of the sideways market we’ve experienced for the past decade.
In partnership with former Trillium colleague Adam Seitchik, now of Auriel Capital Management of London, Trillium is developing the first absolute return, market neutral equity fund that rigorously incorporates environmental, social and governance (ESG) risks into its stock selection process. We believe the Trillium Absolute Return Fund will not only respond to a growing need among investors but also advance the discipline of socially responsible/ESG investing. We expect to roll out the fund sometime in the first quarter of 2011. Stay tuned.
Part II of this article will appear in next quarter’s Investing For A Better World®