Swedroe: Fishing For Things To Worry About?

February 23, 2018

There is always a reason for investors to worry about the stock market, be it valuations at historically high levels, economic risks, the risk of inflation or geopolitical risk. That is why there is an equity risk premium, and why, historically, it has been large enough to be called the equity premium puzzle.

I recently noted that the news on the economic front has been just about as good as it gets. In fact, for the first time since before the financial crises, almost all developed and emerging market countries have improving economies, with growth, and estimates of future growth, increasing.

I also noted that the news on the inflation front has been quite benign. Finally, with the recent $1.5 trillion tax cut, and further fiscal stimulus from the agreement on the spending bill reached not long ago to avoid a default on government debt, expectations for U.S. economic growth and corporate earnings reports have been strong.

In fact, most quarterly earnings reports have been coming in at higher than estimates. The latest estimate of operating earnings for the S&P 500 in 2018 is about $155, up from about $132 in 2017, an increase of 15%. Surprisingly, at least to most forecasters, a weaker dollar is helping by increasing the earnings of U.S. multinationals.

Based on the above, I concluded that I did not believe there was anything in the economic data that would have caused a crash in stock markets. I then provided other possible explanations for the recent dip.

Historical Record

Before we go into the main subject of this post, it is worth looking at the historical record on crashes like the one we experienced this month. The recent crash saw the market fall about 10%. Reviewing the data since 1970, and looking only at calendar months, I found seven other months when the U.S. market fell at least 10%. The return over the next quarter averaged 7.9%, and over the next 12 months, it averaged 22.4%—both well above the historical average.

Of course, that’s not a guarantee regarding future returns. Thus, it should not be taken as a buying signal. However, it does show that the winning strategy was to avoid panicked selling, to which many, especially those who assume more risk than they have the ability or willingness to take, succumb.

Turning to the subject of today’s post, as the director of research at Buckingham Strategic Wealth and The BAM Alliance, I’ve been getting questions about whether we could see a bear market in stocks accompanied by a bear market in bonds.

In other words, unlike in 2008, when safe bonds provided strong gains to help offset the huge losses in equities, investors have asked whether that might not be the case in the next bear market. The answer is an affirmative yes—it definitely can happen. However, it’s been so long since it did happen that many of today’s investors either were not alive or were too young to experience the pain.

A Long Time Ago ...

The last year of negative returns to both stocks and bonds occurred 49 years ago, in 1969, when the S&P 500 lost 8.5%, and long-term government bonds lost 5.1% (five-year Treasuries lost just 0.7%). While those losses are not dramatic, consider that, as 1969 began, the Shiller CAPE 10 was about 22. As we entered 2018, it was about 32.

Thus, valuations could fall a lot further if risks increase and investors demand a larger risk premium. The yield then on the long-term Treasury bond was about 6%. Today yields are a lot lower. The result is not only that yields could rise much more, but that the same change in interest rates could lead to a larger drop in bond prices because the duration of a bond with a lower yield is longer (the same change in yields leads to a larger change in price). Thus, it’s important to not be lulled by the relatively small losses that occurred in 1969.

The lack of a recent event, or even one that investors have ever experienced, could lead many to conclude that it is so unlikely to occur again they don’t have to consider the risks and plan for them.


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