As the last vestiges of a rather cold winter come to an end, I wonder if the chilling price-drops in equity markets may at long last be ready for recovery.
At the end of February, the S&P 500 index was 50% below where it was in March of 2000, almost 9 years before. Since then, March has come in as a bear and is leaving like a bull (if you’ll forgive my mangling a metaphor). Overall, major equity markets have recovered about 10%. Is this the start of the long road back or the proverbial dead cat bounce that we have experienced so often before?
To be honest, it is difficult to say, but I have been researching some information that will help us make better decisions about our asset allocations; improve our understanding of secular bull and bear markets; and hopefully provide us with an answer.
But first, what do I mean when I mention a “Minsky moment” in the title?
Hyman Minsky was a well known economist who, amongst other things, developed theories about how long periods of stability would eventually lead to instability. The following is a clear definition of what is known as a Minsky moment, as taken from Wikipedia.
“At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. “This is likely to lead to a collapse of asset values,” Mr. Minsky wrote.
When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash [that can force central bankers to lend a hand]. At that point, the Minsky moment has arrived.”
Essentially, the basic underlying principle is that the longer a trend exists with no change (and no apparent risk), the greater the volatility will be when that trend finally ends (as we have seen in almost all asset classes – especially housing).
Let’s look at some historical data, illustrated in the three charts that follow, and explore how Minsky’s concept applies to the trends, volatility and cycles of the stock market and what that may indicate for us going forward.
- The S&P 500 relative performance between U.S. stocks and bonds from 1801 to 2009 (including dividends)
- The S&P 500 between December 1965 and December 1978 (index only, not including dividends)
- The S&P 500 between March 2000 and February 2009 (index only, not including dividends)
The first thing I should mention is that this chart (not including my own comments in the black bubbles) was put together by a very well respected analyst named Rob Arnott. It was featured in both John Mauldin’s newsletter and Alan Abelson’s “Up & Down Wall Street” column in Barron’s Magazine from the week of March 27, 2009.
[If you do not already subscribe to John Mauldin’s weekly newsletter, I highly recommend it. You’ll have a better handle on global markets and economic events by investing 15 minutes a week with his insightful analysis. You can visit his site and subscribe for free by clicking on the link above or visiting directly at www.2000wave.com.]
To me, this chart tells us the following:
- Many asset allocation models suggest that equities outperform bonds by as much as 5% per year over long periods of time. In his 200-year analysis, Arnott is showing that the actual difference is half that, or 2.5% per year. That is the “equity premium.”
- There can be long periods of time when bonds outperform equities. While many investors are aware this occurred during the Great Depression and WWII, most of us would be surprised to learn that bonds also outperformed equities between 1968 and 2009. (So for the last 41 years, bonds have been the better investment.)
- This does not mean equities performed poorly (in fact, $10,000 invested in the S&P 500 in 1968 is now worth $253,000 for an annualized return of 8.38%); it points out that bonds generated the same return over the last 40 years or so. (By bonds we are referring to longer-term U.S. Treasury Bonds.)
- During the first 14 years of this analysis, interest rates were rising (1968-1982) and bonds performed poorly. But since then, bond rates have dropped from about 18% to 2% (for U.S. Government Bonds). This has been the longest bull market in bonds ever (27 years).
As mentioned above, Arnott’s analysis shows that, over a 200-year period, equities provide an average risk premium of about 2.5% above bonds. Since they have provided no return over bonds for the last 41 years, there is a reasonable chance they could provide a considerably better result as we go forward.
This raises the question: is the glass half full or half empty? It might be depressing for equity investors to realize that since the 1960’s they have done no better than a decent bond portfolio. If equities had averaged 2.5% more than bonds for the last 41 years, the $10,000 we mentioned earlier would now be worth $855,000 versus the $253,000 it is actually worth. To me, that suggests a very good chance of mean reversion – i.e., equities could now outperform bonds by more than 2.5% per year for the next 41 years.
In this case the Minsky moment that may have ended is the one related to bonds not equities.
Now let’s look at the other two charts.
For the 13 years between 1965 and 1978, the S&P 500 was range-bound and there was no change in the price of the index. However, as you can see from the chart, the markets were very volatile with bull rallies of as much as 75% and bear market corrections up to 45%.
In the end, if you did not get dividends, this is what you saw:
- Very little cash flow.
- Extreme, stomach churning markets.
- Loss of capital after inflation of about 50%.
- Markets that did not gain good traction until 1982 when the recession of 1981/82 ended and interest rates started to decline.
- The nadir of this long secular bear market occurred in 1974. From that point until 1982, the S&P 500 rose more than 200% – in this time period, profits were made with a combination of both capital gains and dividends. However, to invest at the bottom of a market in a severe recession takes a level of confidence most investors do not possess.
If we fast forward to our current markets, they look like this:
So what other observations can we make?
- At some point the severe recession we are in will end.
- Market timing rarely works, and when it does it is usually just luck.
- While high grade government and corporate bonds have outperformed equities over the last 40 years, they are now at extremely low yields.
- The 1970’s show that markets can have many false starts (dead cat bounces) before they can gain permanent traction. They also reveal that the low point in equities often occurs long before recessions end (e.g., 1974 for the low point of the S&P 500 vs. 1978-1982 for the real recovery and beginning of the secular bull market).
- Today’s equity levels have at least some resemblance to the nadir of equity markets that we experienced in 1974. As Mark Twain said, “history does not always repeat itself, but it does rhyme.”
- It is much easier to be right about the longer term than the next six months. In this environment, equities could easily fall further.
If your investing time frame is 5 -10 years or longer, then from these levels we feel you will be well rewarded as long as the choice in equities includes dividend-paying companies with strong balance sheets.
There are many factors to successful investing and among them are:
- Buying assets that are below their intrinsic value.
- Buying assets that have underperformed for an extended period of time.
- Buying assets in recessions or depressions.
- Keeping leverage low and manageable.
- Buying assets that generate strong cash flows.
- Being prepared to be a continuous purchaser over time in markets such as these (dollar cost averaging).
Markets may be volatile, but, as history shows, that tends to be the norm and not the exception.
This recession is, in our opinion, going to last longer than most individuals think and we could easily retest the market lows we saw late last year and early this year. While the recession may last a while longer, I believe it is time to begin steadily acquiring quality assets.
I think the end of this Minsky moment is getting closer.