[This blog was originally published by Summitas at www.Summitas.com]
During extraordinary market conditions of all kinds – good and bad – it is usual to hear people say “It’s different this time.” Of course, every market environment is different from every other market environment, but what these people are saying is that market conditions today are so exceptional, so completely unprecedented, that investors will need to reassess everything they thought they knew – or face serious consequences.
We heard this during difficult environments, like the Great Depression, 1974, 1987, and 2002, and we’re hearing it again today. But it wasn’t different on any of those occasions: investors who kept their wits about them and continued to follow traditional, thoughtful investment strategies were well-rewarded in every case.
We also heard this refrain during very strong markets: the roaring Bull Market of the late 1920s; the Nifty Fifty Era of the late 1960s; the Tech Bubble of the late 1990s; and the recent liquidity bubble. In each case, true believers insisted, “It’s different this time.” What they meant was that traditional valuation metrics were so outmoded that what appeared to be preposterously high prices were actually very attractive. In each case, the true believers were wrong – traditional valuations reasserted themselves with a vengeance and those who thought it really was different that time were wiped out.
But let’s not make the mistake of believing that just because something hasn’t happened before, it can’t happen at all. In fact, just in the past 20 months we’ve seen a number of events occur in the capital markets that most market participants believed were statistically impossible. More important, very fundamental shifts in capital market metrics really do happen from time to time, and the failure to recognize that “It’s different this time” can, indeed, have serious consequences.
Consider the year 1958. Up until that time the dividend yield on stocks had always been higher than the interest yield on bonds. This seemed altogether proper to sensible investors: stocks were unsecured claims and therefore risky, and unless they paid a higher yield than bonds to compensate for this risk, no one would buy stocks. But in 1958, for the first time, dividend yields fell below bond yields. Some people claimed, “It’s different this time,” but many gray-haired investors rolled their eyes and assured anyone who would listen that the yield environment in 1958 was simply a temporary aberration. Soon enough, they insisted, the proper order of things would be restored.
But it didn’t happen. For 50 long years dividend yields stayed stubbornly below bond yields, and investors who didn’t alter their investment strategies from bond-centric to equity-centric got left behind in the dust, because the total return on stocks during this period far exceeded the return on bonds. Then, in November of 2008, yield differentials reversed themselves again, and for the first time in half a century dividend yields rose above bond yields. Again, some people are claiming that, “It’s different this time.” But many gray-haired investors (like me) are rolling our eyes and saying, “Nonsense, the current yield environment is driven by a panicky flight to quality and soon enough bond yields will rise back above dividend yields.”
But will they? Weren’t we wrong in 1958? Who’s to say we’re not wrong today? Maybe bond yields will stay below dividend yields until 2058. Who knows?
My point is that current market conditions, while not as unprecedented as many people are claiming (I have four words for them: The Panic of 1873), are certainly extraordinary. Instead of assuming confidently that our traditional approach to managing capital is the proper one, might it not behoove us at least to examine the issue?
Which is what I’m going to do in the next few articles. For example, my next article will address what we might call the “core” core investment assumption—the one underlying all others even if it isn’t regularly articulated—which is that most of the world’s commercial nations will continue to conduct their affairs broadly in accordance with free-market principles. If this assumption somehow proves inaccurate, virtually everything we think we know about the investment process can be tossed out the window.
Other articles will articulate the more traditional assumptions on which most good financial advisors base their long-term investment advice, and will then ask whether, given recent events, any of those assumptions should be revised. I will look specifically at the long-term risk, return, and correlation assumptions we use in our asset allocation modeling. I will address an issue that is on almost everyone’s mind: How can portfolio modeling exercises take extreme events into account without imposing unacceptably large opportunity costs on investors? Finally, I will review the various asset categories individually to examine future prospects for those sectors—especially sectors, like hedge, that disappointed in 2008.
Please note that this article is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.