by David Robertson, CFA
September 2016
"Bye Bye Miss American Pie" is a classic song by Don Mclean that regaled the bygone era of 1950s-style rock and roll [here]. By 1971, when the song came out, music had changed a lot - which reflected the changing temperament of the country after several years of protests in the 1960s and an escalating conflict in Vietnam. In recalling how he can, "still remember how that music used to make me smile," Mclean conjures up nostalgia for a time when music was mainly about dancing and being happy. The song marked the end of an era in music but also more broadly of American culture.
So too may we be coming to the end of another era - that of the nearly dogmatic inclusion of stocks in investment portfolios. While consistently double digit returns in the 1980s and 1990s endeared many investors to the virtues of stocks, a fresh look reveals that nearly every argument for stocks is weaker now than it was twenty or thirty years ago. In short, several factors merit not only a fundamental rethink of the role of stocks in one's portfolio, but also of the entire process of managing wealth.
One of the biggest reasons for owning stocks is to participate in economic growth. As Gary Shilling explained in his March 2016 newsletter, "In the long run, the growth rates for nominal GDP and profits are similar. This means that over time, stock prices ride up with nominal GDP."
As Shilling also explains, however, economic trends have not been favorable - and this hurts the case for stocks. Specifically, the recovery since 2009 has been the weakest in at least the last 60 years at 2.2% per year. Indeed, the last three economic recoveries (at 2.8% in 2002 and 3.6% in 1991) are the three weakest in that time period and each one has been weaker than its predecessor.
Further, underlying trends in the key components of economic growth, population growth and productivity, are both weak. Recent productivity results have actually been negative. As the Wall Street Journal reports [here]: "Nonfarm business productivity—the goods and services produced each hour by American workers—decreased at a 0.5% seasonally adjusted annual rate in the second quarter." The article goes on to explain that, "The longest slide in worker productivity since the late 1970s is haunting the U.S. economy’s long-term prospects." As the economy's prospects are "haunted", so too are those for stocks.
If stocks were cheap and poor economic prospects were fully discounted, that would be one thing, but they aren't. Valuation is another factor working against stocks as we have mentioned before [here]. The old adage "buy low and sell high" doesn't work if you keep buying stocks at high and higher valuations.
While valuations do tend to move in cycles, they move in very long cycles and many investors do not fully appreciate the ramifications. Financial market history reveals pretty clearly that valuation cycles tend to last two or three decades. For individuals, that is a huge portion of one's adult life which can fundamentally reshape retirement plans if caught at the wrong time. Even for most organizations, that is a long enough period to outlast most board members, organizational leadership and perhaps even investment policy. As a result, it pays to consider the valuation risks seriously for most investors.
In addition to capturing economic growth, another core rationale for owning stocks is to receive the only "free lunch" in investing: diversification. Because stocks tend to behave differently than bonds and other assets, much of the risk of owning stocks can be mitigated by diversifying across different asset classes. This is a foundational concept for the vast majority of portfolio construction and wealth management.
In real life, however, correlations across asset classes are not static over time. Indeed, as Zerohedge reports in a piece [here], the markets are currently experiencing an "elevated level of cross-asset correlations." More specifically, "As Bloomberg notes, the Credit Suisse data, which tracks price relationships in equities, credit, currencies and commodities, shows that different markets are influencing each other in 2016 at a higher rate that any time since the measure was invented in 2008. The indicator assesses how much movements in one market are statistically explained by movements in another." So while almost everyone pays tribute to the importance of diversification, very few call it out when it is not working well.
Finally, another development that has weakened the case for stocks is that the public markets for stocks have become less dynamic and, arguably, less capable of the same levels of value creation as in the past.
One of the ways in which markets have become less dynamic is through a quiet but powerful consolidation. For instance, the Economist reports [here] that "The number of listed companies in America nearly halved between 1997 and 2013, from 6,797 to 3,485, according to Gustavo Grullon of Rice University and two colleagues, reflecting the trend towards consolidation and growing size." That's right; the number of stocks is almost one-half of what it was twenty years ago!
As the number of public stocks has been shrinking, the existing ones have gotten even bigger. According to the Economist, "The share of nominal GDP generated by the Fortune 100 biggest American companies rose from about 33% of GDP in 1994 to 46% in 2013." The Financial Times also reported [here] that, "Companies are growing older, competition is less fierce and market power is consolidating in the hands of a few large companies in many industries."
While consolidation has shrunk the number of public companies, the reallocation of profits from reinvestment to distributions to shareholders has reduced the future value creation potential of those companies that remain.
As William Lazonick describes in the Harvard Business Review [here], "The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees."
Laurence Fink, the chairman and CEO of BlackRock, addressed the issue in an open letter to corporate America in March: "It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies ... Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks."
Another way in which public markets have become less dynamic is through a weakened supply of new public companies. It used to be the case, as noted [here], that "Getting on to a public market gave a young company credibility - and it was essential if a company needed large chunks of capital for investment." No longer. Now, "the more entities such as Nasdaq build financial infrastructure for non-listed companies - the less practical need there is to list early, if at all." As a result, according to the Economist [here], "The IPO market has shrunk into insignificance; about 90% of today's successful startups 'exit' by selling themselves to an established company."
The trend towards raising private capital, rather than raising public capital through an IPO, seems to be getting even stronger. As reported [here], "For US venture backed tech companies, the private market has outstripped the public market when it comes to raising capital this year [2015]. So far they have raised just $600m through initial public offerings, and 35 times as much — or $20bn — through private offerings."
While the relative merits of private vs. public capital can be debated, one consequence is clear for investors: The notion of "finding the next Microsoft" has increasingly become an anachronism. The next Microsoft is likely to wait far longer to go public or to defer accessing public markets altogether. Either way, there will be far less potential for investors in public markets.
For a wide variety of reasons then, the case for stocks is not nearly as attractive now as it was twenty or thirty years ago. The combination of declining economic strength, high valuations, increasing asset correlations and eroding dynamism in public markets provide more than enough reasons to treat stocks with a dose of caution.
This is especially relevant for investors (and managers, advisers, and consultants) that were fortunate enough to benefit from the nice run in stocks in the 1980s and 1990s. Many have come to view stocks almost as a "utility" that regularly provides attractive returns with manageable risk. This is somewhat understandable given that many of the changes in the markets have been under-reported. But it is almost impossible to manage against risks you aren't even looking for. Too many market participants, indoctrinated by a "cult of equity", are not recognizing the end of an era.
While it is clear that the case for stocks is weaker than it was twenty or thirty years ago, it is also important to not overstate the case. Stocks are still absolutely useful vehicles for allocating capital across an economy and for generating returns in a portfolio. We do expect significant opportunities for investing in stocks to return at some point. For younger investors, who have suffered through one or two big market crashes, it may be easy to write off stocks as a useful asset class. Being dogmatically negative on stocks would also be a mistake.
Either way, there is no longer a simple and easy way to approach stocks. This creates an important implication regarding portfolio construction and wealth management. While such simplicity "used to make investors smile", that era is past and it is time to adapt to a new one.
Part of this evolution will involve investors taking a more active and attentive role in managing their investments than they have in the past. This is very different than buying and holding forever or setting a simple asset allocation and checking in every once in a while.
The new approach also means expanding perspectives so as to capture an ever-widening set of potential outcomes. Active discussion and problem solving will be required to mitigate risk as conditions change. It also means aggressively managing costs by doing what one can and scrutinizing any outsourcing because it will become increasingly costly to be completely "hands off". Finally, it also means finding and leveraging access to investment expertise in more modular and cost effective ways.
In short, while it may be pleasant to regale in nostalgia for happier days of yore, the simple fact is that times change. As they do, being forewarned is being forearmed.
September 2016
"Bye Bye Miss American Pie" is a classic song by Don Mclean that regaled the bygone era of 1950s-style rock and roll [here]. By 1971, when the song came out, music had changed a lot - which reflected the changing temperament of the country after several years of protests in the 1960s and an escalating conflict in Vietnam. In recalling how he can, "still remember how that music used to make me smile," Mclean conjures up nostalgia for a time when music was mainly about dancing and being happy. The song marked the end of an era in music but also more broadly of American culture.
So too may we be coming to the end of another era - that of the nearly dogmatic inclusion of stocks in investment portfolios. While consistently double digit returns in the 1980s and 1990s endeared many investors to the virtues of stocks, a fresh look reveals that nearly every argument for stocks is weaker now than it was twenty or thirty years ago. In short, several factors merit not only a fundamental rethink of the role of stocks in one's portfolio, but also of the entire process of managing wealth.
One of the biggest reasons for owning stocks is to participate in economic growth. As Gary Shilling explained in his March 2016 newsletter, "In the long run, the growth rates for nominal GDP and profits are similar. This means that over time, stock prices ride up with nominal GDP."
As Shilling also explains, however, economic trends have not been favorable - and this hurts the case for stocks. Specifically, the recovery since 2009 has been the weakest in at least the last 60 years at 2.2% per year. Indeed, the last three economic recoveries (at 2.8% in 2002 and 3.6% in 1991) are the three weakest in that time period and each one has been weaker than its predecessor.
Further, underlying trends in the key components of economic growth, population growth and productivity, are both weak. Recent productivity results have actually been negative. As the Wall Street Journal reports [here]: "Nonfarm business productivity—the goods and services produced each hour by American workers—decreased at a 0.5% seasonally adjusted annual rate in the second quarter." The article goes on to explain that, "The longest slide in worker productivity since the late 1970s is haunting the U.S. economy’s long-term prospects." As the economy's prospects are "haunted", so too are those for stocks.
If stocks were cheap and poor economic prospects were fully discounted, that would be one thing, but they aren't. Valuation is another factor working against stocks as we have mentioned before [here]. The old adage "buy low and sell high" doesn't work if you keep buying stocks at high and higher valuations.
While valuations do tend to move in cycles, they move in very long cycles and many investors do not fully appreciate the ramifications. Financial market history reveals pretty clearly that valuation cycles tend to last two or three decades. For individuals, that is a huge portion of one's adult life which can fundamentally reshape retirement plans if caught at the wrong time. Even for most organizations, that is a long enough period to outlast most board members, organizational leadership and perhaps even investment policy. As a result, it pays to consider the valuation risks seriously for most investors.
In addition to capturing economic growth, another core rationale for owning stocks is to receive the only "free lunch" in investing: diversification. Because stocks tend to behave differently than bonds and other assets, much of the risk of owning stocks can be mitigated by diversifying across different asset classes. This is a foundational concept for the vast majority of portfolio construction and wealth management.
In real life, however, correlations across asset classes are not static over time. Indeed, as Zerohedge reports in a piece [here], the markets are currently experiencing an "elevated level of cross-asset correlations." More specifically, "As Bloomberg notes, the Credit Suisse data, which tracks price relationships in equities, credit, currencies and commodities, shows that different markets are influencing each other in 2016 at a higher rate that any time since the measure was invented in 2008. The indicator assesses how much movements in one market are statistically explained by movements in another." So while almost everyone pays tribute to the importance of diversification, very few call it out when it is not working well.
Finally, another development that has weakened the case for stocks is that the public markets for stocks have become less dynamic and, arguably, less capable of the same levels of value creation as in the past.
One of the ways in which markets have become less dynamic is through a quiet but powerful consolidation. For instance, the Economist reports [here] that "The number of listed companies in America nearly halved between 1997 and 2013, from 6,797 to 3,485, according to Gustavo Grullon of Rice University and two colleagues, reflecting the trend towards consolidation and growing size." That's right; the number of stocks is almost one-half of what it was twenty years ago!
As the number of public stocks has been shrinking, the existing ones have gotten even bigger. According to the Economist, "The share of nominal GDP generated by the Fortune 100 biggest American companies rose from about 33% of GDP in 1994 to 46% in 2013." The Financial Times also reported [here] that, "Companies are growing older, competition is less fierce and market power is consolidating in the hands of a few large companies in many industries."
While consolidation has shrunk the number of public companies, the reallocation of profits from reinvestment to distributions to shareholders has reduced the future value creation potential of those companies that remain.
As William Lazonick describes in the Harvard Business Review [here], "The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees."
Laurence Fink, the chairman and CEO of BlackRock, addressed the issue in an open letter to corporate America in March: "It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies ... Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks."
Another way in which public markets have become less dynamic is through a weakened supply of new public companies. It used to be the case, as noted [here], that "Getting on to a public market gave a young company credibility - and it was essential if a company needed large chunks of capital for investment." No longer. Now, "the more entities such as Nasdaq build financial infrastructure for non-listed companies - the less practical need there is to list early, if at all." As a result, according to the Economist [here], "The IPO market has shrunk into insignificance; about 90% of today's successful startups 'exit' by selling themselves to an established company."
The trend towards raising private capital, rather than raising public capital through an IPO, seems to be getting even stronger. As reported [here], "For US venture backed tech companies, the private market has outstripped the public market when it comes to raising capital this year [2015]. So far they have raised just $600m through initial public offerings, and 35 times as much — or $20bn — through private offerings."
While the relative merits of private vs. public capital can be debated, one consequence is clear for investors: The notion of "finding the next Microsoft" has increasingly become an anachronism. The next Microsoft is likely to wait far longer to go public or to defer accessing public markets altogether. Either way, there will be far less potential for investors in public markets.
For a wide variety of reasons then, the case for stocks is not nearly as attractive now as it was twenty or thirty years ago. The combination of declining economic strength, high valuations, increasing asset correlations and eroding dynamism in public markets provide more than enough reasons to treat stocks with a dose of caution.
This is especially relevant for investors (and managers, advisers, and consultants) that were fortunate enough to benefit from the nice run in stocks in the 1980s and 1990s. Many have come to view stocks almost as a "utility" that regularly provides attractive returns with manageable risk. This is somewhat understandable given that many of the changes in the markets have been under-reported. But it is almost impossible to manage against risks you aren't even looking for. Too many market participants, indoctrinated by a "cult of equity", are not recognizing the end of an era.
While it is clear that the case for stocks is weaker than it was twenty or thirty years ago, it is also important to not overstate the case. Stocks are still absolutely useful vehicles for allocating capital across an economy and for generating returns in a portfolio. We do expect significant opportunities for investing in stocks to return at some point. For younger investors, who have suffered through one or two big market crashes, it may be easy to write off stocks as a useful asset class. Being dogmatically negative on stocks would also be a mistake.
Either way, there is no longer a simple and easy way to approach stocks. This creates an important implication regarding portfolio construction and wealth management. While such simplicity "used to make investors smile", that era is past and it is time to adapt to a new one.
Part of this evolution will involve investors taking a more active and attentive role in managing their investments than they have in the past. This is very different than buying and holding forever or setting a simple asset allocation and checking in every once in a while.
The new approach also means expanding perspectives so as to capture an ever-widening set of potential outcomes. Active discussion and problem solving will be required to mitigate risk as conditions change. It also means aggressively managing costs by doing what one can and scrutinizing any outsourcing because it will become increasingly costly to be completely "hands off". Finally, it also means finding and leveraging access to investment expertise in more modular and cost effective ways.
In short, while it may be pleasant to regale in nostalgia for happier days of yore, the simple fact is that times change. As they do, being forewarned is being forearmed.
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