This is the question that many individual and
institutional investors are asking themselves nowadays.
Bulls say that stock markets are reasonably valued by
historical standards and, in any case, offer the hope of long term gains while
bonds are in nosebleed territory and ready for a fall.
Brown bears point out that central banks have
distorted all asset valuations by pushing the cost of money to near zero, and
that when normality returns, stocks will slip; black bears say that public
finances are so weak and private businesses so frightened that economic growth
is unlikely to exceed its current lethargic pace and therefore that bond yields
can stay at their depressed levels for years to come.
A
few charts will put the above arguments into some perspective. Below is a chart of the S&P500 from 1982
to the present. The red line is a linear
regression of the value series while the green lines represent one and two
standard deviations above and below the long term trend.
Looking at the chart, the current S&P500 isn’t cheap,
but it remains within normal volatility boundaries.
Still, even allowing for the “compression” effect
due to the fact that early S&P500 values were below 400 while later ones topped
1,500, it is apparent that volatility has increased in recent years: the biggest drop in the 1980s was 33% in 1987,
followed by a 19% correction in 1990.
By contrast, we had a 42% drop in 2000-2002 and a
46% drop in 2008-2009. As years pass by,
the falls and the rebounds get steeper.
A preliminary conclusion is that, even if stock
markets are not overvalued, they are more volatile; if long term investors want
to remain long, they should be ready for unsettling times. In other words, they should carry ZERO margin
loans.
The
next two charts add more context to the stock markets’ past performance. The top one graphs the yield on 10 year treasuries
(GT10 Govt) and the US consumer price index (CPI) over the last 50 years. The bottom one graphs the real yield on 10
year treasuries after deducting inflation (i.e., GT10 Govt minus CPI).
A few observations: (1) nominal and real
yields as well as inflation have tapered since 1980; (2) current real and
nominal yields are as low as they have ever been (except for the mid and late
70s when real yields were sharply negative as a result of an oil-driven spike
in inflation); (3) nominal treasury yields have fallen faster than inflation in
the last 30 years.
Unless one anticipates a Japanese-like deflation in
the US, which is unlikely to happen, bond yields can’t go further down and
indeed are bound to go up quite a bit. Should
they get back to the average of the past 10 years, holders of 10 year
treasuries would lose 12% of their principal; their loss would deepen to 23% if
yields reverted to their 1990-2013 average.
Nowhere is the risk greater than in emerging markets
sovereign debt. Yes, we have heard that
Brazil, Russia and the like have better public finances, less debt relative to
their GDP, etc. But they remain
economies with much promise but less robust financial, political and judicial institutions,
too much poverty and immense investment needs.
Booming demand for commodities has abated lately, a clear negative for
most of them. And sometimes, these bright
promises dim as fast as they arose in the first place: the structural reforms of President F. H.
Cardoso were followed by a return to government meddling and a series of
scandals under President Lula, and while President Rousseff has taken a firm
stand on corruption, the general economic policy remains the same. In the span of fifteen years, Venezuela has
turned from a middle of the pack emerging economy to a basket case which could
explode at any moment. Even China, which
had clocked (published) economic growth rates in the 9%-10% range is now
slowing down and trying to engineer a very difficult policy change.
And where do 10 year sovereign EM debt trade at? Brazil trades at under 3.4% p.a., Colombia at
3.6% p.a., Russia at 3.2% p.a., Indonesia at 3.7% p.a., the Philippines at 3.3%
p.a[1]. These rock bottom yields reflect two factors:
investors/traders racing for yield (after all, these EM bonds return 60% to 80%
more than US treasuries!), and their conviction that they can sell faster than
the other guy when markets sell off.
Volatile stuff!
So what do we do?
Cash or stocks? I would say some
of both. Asia may well be the future
economic center of gravity of the world, but for the time being the US
are. The US also enjoy the richest
domestic market (a definite advantage when the world economy stumbles along), a
vast reserve of energy, and, yes, a culture and structure conducive to
innovation and entrepreneurship. Europe
offers some interesting valuations, particularly in those top companies that
enjoy a strong domestic base and are globally competitive. Finally, there is Latin America, or at least
parts of it…
