The Financial Times runs an excellent analysis by columnist John Authers looking at how the “cult of equity” has been dead wrong.
It’s something we’ve touched on here and there—that the idea that investing in stocks always works over the long haul has been proven utterly false, but Authers really nails its coffin shut and looks at some of the other serious implications of the bust.
The crash has forced professional investors and academics to question the theoretical underpinnings of modern finance. The most basic assumptions of the investment industry, and the products they offer to the public, must be reconsidered from scratch. Indeed, the very reason for the industry to exist – a belief that experts make the smartest decisions on where people’s money will do best – is up for scrutiny as a result.
See, Wall Street—and much of the business press—doesn’t get this. That’s why I talk about “the bubble” so often. They’ve yet to realize that the Masters of the Universe have done irreparable damage to the conventional wisdom that the markets were a relatively fair place that rewarded patience in the long run. That belief enabled executives to loot their firms for massive pay packages, which the people overlooked as long as they got their small piece of the gains.
But now the regular investor has seen she’s been sold a bill of goods and taken on loads of risk—for what? Returns that equal those of much safer Treasury bonds over the last forty years:
US stocks have fallen more than 60 per cent in real terms since the market peaked in 2000. Anyone who started saving 40 years ago, when the postwar “baby boom” generation was just joining the workforce, has found that stocks have performed no better than 20-year government bonds since then, a forthcoming article by Robert Arnott for the Journal of Indexes shows. These people want to retire soon and the “cult of the equity” has let them down.
Meanwhile, how have CEO’s done over the last forty years while investors have piddled along? Do I need to ask?
Authers also shows how events have perhaps (we can only hope) issued mortal wounds to the efficient-markets theory, that beloved tenet of the laissez-faire folks.
Further, recent experience challenges that basis of modern finance, the “efficient markets hypothesis”, which in its strongest form holds that prices of securities always reflect all known information. This implies that stocks will react to each new piece of information, yet without following any set trend – a description that cannot be applied to the events of the past 18 months.
I love this kind of long-term analysis, something we get far too little of in business reporting:
Instead, the cult of the equity and the efficient markets hypothesis begin to look like phenomena born of the uniquely positive conditions in the middle of the last century. For decades until 1959, the yield paid out in dividends on stocks was higher than the yield paid out by bonds. This was to compensate investors for the extra risk involved in buying equities. In 1951, as the building blocks of the efficient-markets theory began to appear in academic journals, US stocks yielded as much as 7 per cent, compared with only 2 per cent on bonds.
“The 1950s marked the start of a period of relative peace and prosperity. It came on the heels of a tumultuous 50 years that included two world wars and an economic depression. In hindsight, the case for equities over bonds was especially compelling in the early 1950s,” says Robert Buckland, chief global equity strategist for Citigroup.
The impact of this shift in conventional wisdom will be far-reaching, Authers writes. Over the last thirty years, risk has shifted onto individual Americans. The advent of the 401k supposed that the average Joe would be fine investing in equities over the long haul. Those staid old pensions look pretty good now.
That growth potential made pension funds boost their allocations to equities. In the US, and later elsewhere, legislation gave individual investors more power over their retirement funds but also required them to take on the risks. As employers were no longer guaranteeing them a proportion of their final salary on retirement. Savers’ money went heavily into equities. Then came the bear market of this decade.
Another casualty will likely be the mutual-fund industry, which research has long shown perform worse on average than the stock indexes.
The traditional mutual fund, in which managers run a portfolio of about 100 stocks and attempt to beat a benchmark index, may be another casualty. Last year, most equity mutual funds failed to beat their benchmark indices, even though their managers had the freedom to move into cash and to pick stocks. Mr Malkiel points out that of the 14 funds that had beaten the market in the nine years to 2008, only one did so last year. Both efficient-markets and behavioural economists say it is better just to match the index, with a tracking fund, and avoid the fees incurred in unsuccessful attempts to beat the market.
There will be seismic changes. Here, Authers gets a great quote from the head of MIT’s Financial Innovation Laboratory:
“Periods of extraordinary prosperity have behavioural effects – it gives us a false sense of security and therefore there is too much risk-taking. Eventually that kind of risk-taking is unsustainable and you get a burst of the bubble.”
Once bubbles burst, Mr Lo’s theory predicts, a period of “punctuated equilibrium” will ensue, in which long-engrained behaviours no longer work. “We just had a meteorite hit us in financial markets. There will be destruction of species that have lasted a very long time. Out of the chaos will emerge new species.”
Lots of folks on the inside haven’t yet grasped this.