If the bullish scenario plays out this week, flows are likely to be tilted more so to North America ...
Is ‘Death of Equities’ Hoopla True?
06/01/2012 9:15 am EST
Some 33 years ago, a deep pessimism among individual investors supposedly marked the start of a huge bull market for stocks. Except it didn’t. What about now?
Is this "The Death of Equities" all over again?
The BusinessWeek cover proclaiming "The Death of Equities" in big, bold white type on a black background in August 1979 is infamous as a contrary indicator for (supposedly) marking the bottom of the bear market that ruled the 1970s.
Recently, both the Financial Times (May 25) and The New York Times (May 28) have run stories on the flight of individual investors from stocks. Is this another example of respected financial publications getting the timing of the financial markets exactly wrong? Should you read these current stories as a sign that it’s time to move back into stocks?
Certainly, the stories read that way. By putting the current scorn for stocks in the context of the 1979 BusinessWeek cover, these recent stories suggest that investors today are as shortsighted as those who pronounced the death of equities in 1979.
And the stories imply that investors who are heavily weighted toward bonds instead of stocks are guilty of rearview driving—assuming that they’ll get the same superior returns from bonds over stocks that they have earned in the past.
As much as I’d like to buy that implication—the portfolios I run, real and hypothetical, are after all, long-only and equity-only—I just can’t. I don’t see any evidence that we’re near some kind of replay of the secular bull market that followed the BusinessWeek story. Instead, I think the current, highly volatile, secular sideways market has a lot longer to run.
And the strategy for that kind of market—as I’ve tried to outline in recent columns and blog posts—is very different than the strategy you’d pursue if we were about to launch another secular bull market. (For more on strategies for a sideways market see my column "5 Rules for an X-Files Market" and my Jubak Picks post on "3 Buys for This Sideways Market.")
Let’s take a look at what the infamous "Death of Equities" BusinessWeek cover actually did indicate, and what the extreme dislike of stocks right now suggests you should do as an investor in the near and long term.
How Clear Was the Signal, Really?
The "Death of Equities" cover was actually a pretty lousy contrarian indicator. The great bull market of the 1980s didn’t take off until three years after the cover ran in August 1979.
In July 1979, the Dow Jones Industrial Average was at 879. By July 1982 it had climbed all the way to 896. Yep, that’s a monstrous move of 2.05% in three years. Better than a poke in the eye with a sharp stick, of course, but about as much fun as watching paint dry.
The bull market of the 1980s took off fairly quickly after that, with the Dow roughly doubling to 1,768 by July 1986 and then climbing to 2,693 by July 1989.
The size of that move is so impressive—206% from July 1979 to July 1989—that it seems to make the three lost years of July 1979 to July 1982 irrelevant. Yes, you could have sat on your money for another three years and then plunged into stocks in July 1982 and still made 201%. But it seems ungrateful to quibble about timing when you’re looking at a 206% gain, right?
Not at all. Because this kind of backward-looking "analysis" ignores the effect on returns of the day-to-day swings between fear and greed at the time.
If you’ve been invested in the market in 2011 and so far in 2012, you have had an education in how short-term volatility can leave investors with gains (or losses) that trail the indexes. A market like this—and like the market in 1979 to 1982—presents investors with multiple opportunities to buy high and sell low.
So, for example, to get that 206% gain from July 1979, you would have had to hold on during the correction from February 4, 1980 to April 14, 1980. If you sold then, and bought back in after the market had climbed toward its 1,020 high on April 20, 1981, you would have lost a good portion of that 33.7% gain in early 1981. You’d also have set yourself up for a big loss when the Dow fell back to 789, a drop of 22.6%, by June 14, 1982.
And it’s no good to claim that you wouldn’t have been caught up in those emotional trades because you know what things are worth. In volatile markets, stock prices swing wildly between hope and fear on the slimmest ration of news, frequently overwhelming any calculations of value based on fundamentals.
As the economist John Maynard Keynes wrote, "The market can remain irrational longer than you can stay solvent." (As a successful trader in currencies and commodities who was still wiped out in a bet against the Deutschmark in 1920, Keynes wrote from experience.)
So the first thing we think we know that comes into question is the accuracy of the belief that the BusinessWeek story was a useful contrarian indicator that signaled a buying opportunity.
How Much Do Individual Investors Matter, Really?
The second thing we should question—about the 1979 BusinessWeek story and about more recent versions of the "Death of Equities" scenario—is the cause-and-effect relationship that these stories assume between the enthusiasm of individual investors for stocks and the rise or fall of stock prices.
The BusinessWeek story in 1979 noted that "At least 7 million shareholders have defected from the stock market since 1970, leaving equities more than ever the province of giant institutional investors."
The New York Times story of May 28 quotes a Gallup poll showing that the number of Americans invested in the stock market dropped to 53% in April 2012, from 65% in 2007. The 53% reading is the lowest since Gallup started asking the question in 1998, with a fresh poll every two years.
That trend is mirrored in data from the Investment Company Institute, which shows that the percentage of American households invested directly or indirectly—through a mutual fund or an exchange traded fund—in US stocks has fallen every year since the financial crisis, to a low of 46.4% in 2011, down from a high of 53% in 2001.
I think that’s important to Wall Street companies trying to make a buck from selling stock and equity funds to individual investors. But I can’t see that it had much to do with the direction of the stock market in 1979, or has much to do with it in 2012.
What Really Ignites Stocks
If you’re looking for simple explanations of the long secular bull-market cycle that began in 1982 and trying to predict when the next bull market cycle will begin, I’ve got a simple set of numbers to show you.
In 1977, the yield on the US ten-year Treasury bond was 7.61%; in 1978, 8.41%; in 1979, 9.43%; 1980, 11.43%; and 1981, 13.92%.
Interest rates peaked in 1981, with the federal funds rate hitting 20%, as the Paul Volcker Federal Reserve raised interest rates to punishing levels to break an inflation rate that had climbed to 13.3% in 1979.
In 1982, the yield on the US ten-year Treasury bond was 13.01%. By 1989, it had fallen to 8.49%. By 1999, it was down to 5.65%. By 2009, it had fallen to 3.26%.
And you know what? Yields on Treasury bonds have continued to fall, as global investors—a class dominated by institutional investors, for what that’s worth—have looked to US Treasuries for safety in the Eurozone debt crisis. The yield on ten-year Treasuries declined from 3.26% in 2009, to 3.22% in 2010, to 2.78% in 2011.
Falling interest rates and falling inflation are the best explanations for the long secular bull market. Absent those two closely related factors, individual investors could have loved stocks or hated stocks and we wouldn’t have seen the bull market that stretched to breaking when the subprime mortgage crisis hit in 2007.
Still No Love for Stocks
In the environment since 2007, exactly how irrational have individual investors been in their preference for bonds over stocks?
That drop in Treasury yields—courtesy of the turmoil in Europe—powered the Barclays Capital US 5 to 10 Year Treasury bond index to a total return of 13.95% in 2011. The S&P 500, on the other hand, was up just 2.1% in 2011.
The index was up an additional 1.4% in 2012 through May 29, as US ten-year yields have fallen to 1.75%. (Bond prices rise when yields fall, benefiting bond investors.)
I think it’s hard, on the basis of those performance numbers, to argue that the preference of individual investors for bonds over stocks is anything other than rational. Certainly, individual investors who have been long bonds in the past 18 months or so—a period when a number of very good professional money managers have moved out of US Treasuries—have been very happy with their choice. At least compared with stocks.
Of course, it’s equally hard to argue that this preference for bonds will pay off as handsomely in the future as it has in the past—even the very recent past. After all, there is no way—no matter how much turmoil the European debt crisis creates for Treasury yields—to duplicate the 12.75-percentage-point drop in yields from 1982 to May 2012 if yields are already at 1.75%.
But there’s a big leap of logic to go from arguing that bonds will generate paltry—and eventually negative—returns to a conclusion that stocks are on the verge of a new secular bull market. Rising interest rates and rising inflation (a potential result of a depreciating dollar) aren’t a recipe for a secular bull market, either.
Good News: We Can Still Rally
Fortunately, you can have major rallies without a long-term secular bull market.
During the secular bear market of the 1970s, for example, the Dow rallied 58% from May 1970 to January 1973 before giving back all those gains and more. From December 1974 to March 1976, the Dow rallied 74% before falling 26% from March 1976 to February 1978.
I’d argue that we could still have one of those sharp rallies this year, in an otherwise sideways market, if investors are convinced that China’s stimulus efforts will work. Take a look at the strong rally on Tuesday, May 29, on a belief that China was about to increase economic stimulus.
Unfortunately, it seems you can’t have major rallies without a long-term secular bull market and escape stomach-churning volatility. This pattern is why I’ve been trying recently to sketch in medium-term trading strategies that will take advantage of this volatility.
Finally, I’d argue that the financial markets aren’t made up of just two asset classes, bonds and stocks. There are assets—dividend stocks, for example—that blend some of the performance characteristics of bonds and stocks.
There are some niche sectors—biotechnology and shares of Apple (AAPL), for example—that aren’t closely correlated to the larger asset classes. There’s real estate, of course, either directly or through a real-estate investment trust. And finally, there is the vague but increasingly popular class called "alternative."
(I’ve been doing my homework on "alternative" investments recently, and I’ll report on the topic not too far down the road.)
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