Is it back to the Fifties?
By John Authers
Published: March 24 2009 20:12 |
Last updated: March 24 2009 20:12
My mother is 75,” said Jon Stewart, the
US late-night comedian, at the end of his already famous interview with
Jim Cramer, the television stock market pundit. “And she bought into the
idea that long-term investing is the way to go. And guess what?”
“It didn’t work,” replied Mr Cramer.
The interview this month, in which Mr Stewart
humiliated his guest, has earned a place in American cultural history. Mr
Stewart was articulating a broad sense of betrayal among the populace that
the faith all had been told to put in equities had been misplaced.
That loss of faith spreads beyond retail investors.
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.
tuppence wisely: a father pays out pocket money circa 1955. The children
of that era, now at retirement age, are finding their holdings are far
short of what they expected
Mr Stewart was right about long-term investment, and
not just for septuagenarians. 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.
To find a period that does produce an outperformance
requires a span reaching back a lot further. The 2009 Credit Suisse
Global Investment Returns Yearbook shows that since 1900 US stocks have
averaged an annual real return of 6 per cent, compared with 2.1 per cent for
bonds – while in the UK, equities have beaten gilts with a return of 5.1 per
cent against 1.4 per cent. The problem is that they can perform worse than
bonds for periods longer than a human working lifetime.
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. On these foundations, theorists worked out
ways to measure risk, to put a price on options and other derivatives and to
maximise returns for a given level of risk.
This theory also showed that stocks would outperform
in the long run. Stocks are riskier than asset classes such as government
bonds (which have a state guarantee), corporate bonds (which have a superior
claim on a company’s resources) or cash. So the argument was that those who
invested in them would in the long run be paid for taking this risk by
receiving a higher return. That is now in question.
“There’s no such thing as a risk that you get paid for
taking. The whole point about risk is that you don’t know if you’re going to
be paid for it or not,” says Robert Jaeger at BNY Mellon Asset Management.
“What’s important about the current period is that now it’s true even for a
very long period [that] people haven’t been paid for taking equity risks.
These losses were taken by people who didn’t even think they were taking a
“It supposedly didn’t matter how long you
waited. But the notion that the long run will bail you out no matter what
stupid things you do in the short run I think is dead,” says Robert Arnott,
who examines such performance in a forthcoming article for the Journal of
Indexes. “And the notion that if you have the better asset class it doesn’t
matter what you pay for it is on its deathbed.”
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.
So in 1959, the yield on stocks dipped below
the yield on bonds – and stayed there for almost half a century until the
two crossed once more last November. The theory changed to account for this
and came to hold that bonds yielded more to recognise the superior long-term
growth potential of equities.
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.
If that bear market has damaged the case for
stocks, the efficient markets hypothesis underlying it had been “dying a
natural death for most of this decade”, according to Mr Arnott. In place of
the standard assumption that all decisions are rational, behavioural
economists began substituting findings from experimental psychology on how
people actually make decisions. This helped to explain market crashes and
bubbles, showed that investment decisions could be systematically irrational
and led to attempts to create new models of how markets set prices.
Efficient-markets theorists themselves moved
away from the hardest version of the theory. They identified two anomalies:
in the long run, small companies tend to outperform the larger, while cheap
or “value” stocks (which have a low price in relation to their earnings or
the book value on their balance sheet) outperform more expensive stocks.
Burton Malkiel, a Princeton economics
professor whose book, A Random Walk Down Wall Street, is the most
famous statement of efficient-markets theory, suggests its strongest form is
a straw man. “‘Efficient markets’ has never meant to me that the price is
always right,” he says. “The price clearly isn’t right. We know markets
overreact. They get irrationally exuberant and they get irrationally
pessimistic.” But he says that the key implications remain intact. “What
‘efficient markets’ says is that there are no easy opportunities for
riskless profit. There I still would hold that that part of the efficient
markets is alive and well.”
. . .
Still, the search is on for a new theory to
replace efficient markets. Perhaps most prominently, Andrew Lo, head of the
Massachusetts Institute of Technology’s Financial Innovation Laboratory, has
merged behavioural and efficient markets theory using Darwinian biology.
In his “adaptive markets hypothesis”, markets
behave efficiently during periods of calm. “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.”
Most clearly, the lightly regulated hedge
fund industry – described by Mr Lo as the Galapagos of financial services –
is suffering a shake-out. The sector as a whole suffered an average loss of
18.3 per cent
only its second losing year since 1990, according to Hedge Fund Research of
Chicago. This prompted investors to pull
(€115bn, £105bn) out of the funds. But the worst performing 10 per cent lost
an average of 62 per cent, while the top decile gained 40 per cent. The
Darwinian process is well advanced: 1,471 hedge funds were liquidated last
year, while only 659 new ones were launched, the lowest figure since 2000.
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.
Index funds have caught on over the last two
decades and, recently, their growth has been driven by exchange-traded funds
– index funds that can be bought and sold directly on an exchange. Mutual
funds saw global net sales of $112bn last year but ETFs pulled in a net
$268bn, according to Strategic Insight, a New York consultancy. Barclays
Global Investors reckons there are plans to launch another 679 ETFs around
Index funds could become building blocks for
new retirement savings products that may look much like the pensions that
were the norm until confidence in equity investing took over. As it may be
politically infeasible to continue to expect savers to bear all the
investment risk, some benefits may have to be guaranteed.
Mr Lo suggests that all these developments
are consistent with a new world in which investments will largely be
controlled by “herbivores” – funds that passively aim to match benchmark
indices for a range of asset classes that goes beyond equities. This leaves
room for a smaller group of “carnivores” to try to beat the market by
exploiting inefficiencies and anomalies.
Those carnivores will, moreover, be putting
much less trust in theoretical models. As Mr Jaeger says: “Even with all
those quantitative models, ultimately you have to make a decision. Ideally,
what you are left with is people doing that somewhat old-fashioned kind of
investing where you try to figure things out for yourself.”
OPENED A STATEMENT FOR MONTHS’
Christina Read is 61 and, at least on paper,
has lost half her life’s savings in the past year,
writes Deborah Brewster. “I
started last year with about $400,000 – it’s down to I think about $200,000
now,” says the former dancer who now works as a nanny in Manhattan.
For Ms Read, who is divorced with two
college-age children, the loss means giving up her dream of a house in the
country. “I had been thinking of an old farm, maybe in Nova Scotia. Now it
is pretty much impossible.”
But she is retaining the investments that
have performed so poorly: “I will continue working, I have to keep money
coming in now and, if the market doesn’t come back in the next 10 years, I
will give up on having anything for myself – I will just leave it to my
It is this kind of stoicism that has the army
of brokers, wealth managers, fund managers and product marketers who grew
rich during the boom hoping individual investors will get back into the
markets, and soon. Unless they do, the industry’s outlook will be dire.
Retail investors, mainly through mutual funds, own a much larger part of the
stock and bond markets than ever before. Bob Reynolds, chief executive of
Putnam Investments, says: “It started out with 401(k)s [individual
retirement accounts]. There are more mutual funds than stocks. We are an
Will it stay that way? Ms Read may have sat
tight but hers was not the only response to the world-shaking events. In the
biggest ever exodus of money from professional management, Americans pulled
a net $320bn (£218bn, €237bn) from mutual funds last year. They shifted into
cash, ploughing a net $422bn into money market funds during the year. A net
$212bn went into bank deposits – a figure that has since risen further, to
$370bn for the 12 months to mid-March.
Elbowing aside their advisers, some began
trading their stocks themselves, sharply lifting retail trading volumes as
they tried to take control of their investments. Others have done nothing,
but for different reasons than Ms Read. Hearing the bad news, they have
simply refused to open their financial statements.
“I haven’t opened a statement since October,”
says one Los Angeles-based business owner, who adds that his holdings were
worth more than $3m at the end of 2007 but declines to estimate their value
now. “I know it’s bad, but what can I do about it? There is no point in
depressing myself. I need to focus on my business, which is going well. My
investments are probably pretty much gone ... I had a lot of stocks – bank
stocks, Bear Stearns, they’re gone. I see the statements come in the mail
and I throw them right in the garbage.”
George Gatch, chief executive of JPMorgan
Funds, an arm of
JPMorgan Chase, is working to re-engage
with such investors. “We know how scared people are and we are trying to
convince people to get back in, sit down and talk to their financial
advisers,” he says. The 50,000 advisers with whom JPMorgan works are
reporting that “it is very hard to get their clients to consider the steps
they should take, to do a formal review of their portfolio ... There is a
base of Americans that don’t want to look at their statements any more.”
More than 90m Americans own stocks, through
mutual funds and 401(k) plans. But Mr Reynolds adds: “There is a tremendous
amount of cash on the sidelines today. Retail investors have close to
$13,000bn sitting in money market funds and bank deposits. A year ago there
was $7,000bn. That is billions that is just waiting to come back again.”
In other words, retail investors have the
wherewithal to get things working. The question is whether they will. “The
demographics and people’s objectives haven’t changed because of the market,”
says Mr Reynolds. But, like others, he sees a shift to more conservative
Independent financial advisers who work
outside the big brokerage firms tend to be more pessimistic.
“Once the money gets under the mattress,
which it has, it takes a long time to pry it out again,” says one.
If individual investors stay away, the
consequences for the lucrative wealth management industry and its associated
services and advisers are considerable. Wealth management is seen as a
stable source of revenue for the Wall Street banks as they restructure
themselves for a new era.
Morgan Stanley are merging their wealth
management operations, which will result in an army of more than
to compete with Bank of America’s new “thundering herd”, previously part of
Jim McCaughan, chief executive of Principal
Global Investors, an asset manager, says he does not see a shift away from
using brokers or advisers: “Fear tends to lead people to want to talk to
someone. They will go to the advisers and brokers: that is what has happened
in past bear markets.”
First, however, investors will need to start
looking at their financial statements again.