What now for long-term investors?

Since late 2007, global capital markets have been experiencing one of the most difficult and volatile periods of the past 50 years. In the UK, for example, the FTSE All-Share Index posted a cumulative total return of minus 39.2 per cent over the 17 months from November 2007 through to March 2009. Other asset classes, such as commercial property, have suffered even more severely.

The economic backdrop remains disconcerting. The world faces deepening recession, growing unemployment and troubling outlooks for key industries, such as automobiles. Governments have pledged fiscal and monetary stimulus to help spur economic growth, but constraints exist on the level of support that can be pursued without igniting inflationary fears. Amidst so much uncertainty, the prices of stocks and other financial assets remain highly sensitive to any new information coming into the market.

The turmoil has affected all long-term investors with allocations to equities, irrespective of whether they are investing to achieve growth or income. After suffering such large drops in value and facing ongoing uncertainty, it is natural for them to wonder what to do. Has the world changed?

The Efficient Markets Hypothesis is dead…long live the Efficient Markets Hypothesis (EMH).

The crisis has prompted a number of high-profile market participants to argue that the theories put forward by many financial economists are flawed. In particular, the EMH and Modern Portfolio Theory have been directly criticised. The core argument is that recent events have proven that capital markets are inefficient and irrational, and cannot be relied upon to produce ‘correct’ market prices in all conditions. A related argument is that many of the mathematical risk-management models based on these theories have failed, leading financial companies to materially underestimate the risks they were taking.

These technical discussions are certainly interesting to ponder from an academic or regulatory perspective. But they offer little practical guidance for the typical long-term investor seeking either growth or income. For these investors, the most pressing question is simply: ‘But what should I do now?’

In this respect, those who argue that markets do not price financial assets ‘correctly’ make two very significant inferences. First, they infer that it is actually possible to meaningfully define the ‘correct market price’ at any point in time. And second, by logical extension, they infer that an investor who knows the ‘correct’ price will be able to systematically beat the market by buying when market prices are ‘too low’ and selling when prices are ‘too high’. In other words, if the market is truly ‘inefficient’, then a talented investor should be able to reliably enhance returns and reduce risk by timing the market and picking stocks. It is, therefore, not surprising to see many articles in the financial press advising investors to ‘get out’ of asset classes such as equities during bad times, and to ‘get back in’ when the future looks brighter.

The primary difficulty with this chain of thought is that it is simply not supported by the vast weight of hard statistical evidence. Years of scientific studies have repeatedly shown that it is extraordinarily difficult, and very costly, for any one money manager to systematically profit from perceived ‘inefficiencies’ in the prices of financial assets. In today’s globalised financial system, no single individual or institution can control the market. The result is a never-ending process in which the prices of financial assets are relentlessly moving towards equilibrium. Constant price adjustments occur very quickly in reaction to new information and changes in supply and demand. It is, therefore, not particularly useful for a long-term investor to try to take a snapshot of the market at any point in time and ask whether the price is ‘correct’, or whether market behaviour is ‘rational’. The key question is simply: Can the market be reliably predicted? If the answer is ‘yes’, then market timing and stock picking strategies should produce statistically reliable benefits. If the answer is ‘no’, a more robust approach is necessary. And, to date, the mountain of empirical evidence overwhelmingly supports the ‘no’ conclusion.

Much of this problem is psychological. It is certainly true that, with the benefit of hindsight, much of what transpires in the market seems incorrect and irrational, even obviously so. But this doesn’t mean that it is possible to reliably forecast events before they occur. Even anecdotally, it is easy to see that this is the case. How many market pundits correctly predicted the timing of the crash before it happened? Very few. And will these be the same lucky few who accurately predict the timing of the recovery? Perhaps; but unfortunately we will not know for certain until after the fact, at which point things will again appear completely obvious (in hindsight).

In practical terms, therefore, despite the arcane discussions of financial theory now under way in the financial press, the EMH still offers a crucially important guideline for long-term investors: attempting to time the market is fraught with risk.

Stock market performance during recessions

Some investors think that predicting the market should be easier during recessionary times because the environment is obviously bad. But studies show that forecasting is even more problematic during periods of market stress due to increased volatility.

The UK is currently in its eighth recession since 1950 (a recession is defined as at least two consecutive quarters of negative GDP growth). The pattern of stock market returns during recessions has been closely studied by many researchers, and while each recession is different, there are a few general observations that can be made:

Because stock prices are determined based on future expectations, prices tend to decline before the actual onset of recession. For the market timer, the best time to jump out of the market is usually (but not always) well before the recession begins;
Market price falls can be sharp and quick. If investors wait until the economy is actually in recession to take action, material losses will usually have already occurred;
During the actual recession, stock market returns are not necessarily negative. For the market timer, the best time to get back into the market is usually (but not always) during the recession, before the market expects a recovery; and,
On the price upswing, it is not unusual for gains to be sharp and quick.

These observations highlight two clear risks for the long-term investor who temporarily flees the market in a recession. First, paper losses are crystallised. And second, the investor may not react quickly enough when recovery does occur. By trying to time the market, therefore, the investor has actually entered into a gamble. And, because market recoveries can occur quickly, the cost of being out of the market at the wrong time can be high.

Figure one above shows the performance of the FTSE All-Share Index during UK recessions since 1950. The difficulties of trying to time the market in periods of economic weakness are apparent, particularly since the formal GDP growth for any quarter is known only after the fact.

Stock market performance during financial and banking crises

Some observers have emphasised that the current crisis is very different from a typical recession. In particular, they note that its severity is specifically rooted in bubbles that occurred in the banking and property sectors.

In recent decades, there have been several regional market crashes that have been characterised by severe stress in the banking and property sectors, including: the Asian Financial Crisis of 1997-98 (affecting several countries); the UK secondary banking crisis of 1973-75; the Swedish crisis of the 1990s; and, the Japanese banking crisis of the 1990s. Space does not permit a detailed discussion of each of these crises in this article. However, while each crisis had unique characteristics, several general patterns can be identified:

Before each of these crises, speculative bubbles developed in the local equity and real estate markets (for example, while the UK stock market crash of 1973-75 is normally associated with an oil price shock, it was actually precipitated by a bursting property bubble and the near bankruptcy of many secondary banks). When each bubble subsequently burst, share and property prices declined very dramatically within 12-18 months;
Each bubble was fuelled by banks eager to provide loans, often on relaxed credit terms. When the bubbles burst, the resulting loan losses forced local banks into the arms of the government for support;
When the local stock markets began to recover, large and very rapid stock market gains were typical (for example, in the UK, the FTSE All-Share Index gained over 150 per cent in 1975); however,
In all cases, it was exceedingly difficult to forecast the timing of either the crash or the recovery. The length of time that it took for each local stock market to fully recover varied widely. Some countries rebounded to pre-crash highs within a few years after reaching a bottom; in Japan, however, the recovery process has been much more protracted.

Finally, the depth and global breadth of the current crisis have led some commentators to compare it to the Great Depression of the 1930s. While drawing such a comparison is difficult and of potentially limited value, we do note that the US stock market during the Great Depression exhibited some general parallels with the above observations, particularly in terms of the high market volatility that persisted throughout the period. As shown in Figure two below, after posting sharp declines from 1929-1932, the S&P500 Index actually produced abnormally large positive returns in 1933, 1935, 1936 and 1938.

The key practical conclusion to derive from a review of previous financial crises is that it is notoriously difficult to predict the markets, particularly in periods of high volatility and market stress (when the cost of being wrong is also higher). Investors who try to time the market run the real risk of earning materially lower returns when compared to those who stick with a simple ‘buy and hold’ strategy.

Conclusions for the long-term investor

The first conclusion is that much of the recent discussion in the financial press about ‘market inefficiency’ does not address the practical concerns of many long-term investors. It is certainly true that markets can be strongly affected by emotional factors, and pricing ‘errors’ do occur. However, the key question is whether perceived inefficiencies can be used to accurately forecast the market. Unfortunately, the hard statistical evidence to support such an argument remains extraordinarily weak. Prices adjust very quickly. Sometimes the adjustments are large and without warning.

The second conclusion – investors should make decisions on a forward looking basis rather than looking back at what has already occurred. But it is extremely difficult (if not impossible) to reliably predict the market. To make matters worse, studies show that market volatility increases during periods of economic and financial stress, making prediction even more unreliable. However, the greater risk and uncertainty also mean that expected future stock returns are actually higher at this point in the market cycle. History shows that these higher-return expectations are often (but not always) realised in price recoveries that can occur very quickly. These factors all point to the conclusion that market timing strategies are inherently risky and will succeed only by chance.

The third conclusion – because it is impossible to reliably time the markets, staying fully invested is the most reliable way to achieve solid long-term results. Investors trying to avoid interim risk by fleeing the market are gambling that they can respond correctly on the rebound at a time when emotions and uncertainty are still running high. Unfortunately, the statistical track record of success on this score is not encouraging.

The fourth conclusion – because capital markets can be extremely volatile, maintaining broad diversification is crucially important for long-term investors. Portfolios should not have excessive concentrations in any single country, asset class, sector or company. In the current crisis, losses incurred by broadly diversified portfolios have been nowhere near the devastating levels experienced by concentrated portfolios (for example, those with large holdings of bank shares).

Staying diversified is even more important when market volatility is high. Studies show that the dispersion of individual company returns (even within the same asset class) becomes exaggerated in stressful times because traders react very strongly to news about individual companies as they try to predict the ultimate winners and losers in the economic shakeout. Long-term investors should, therefore, maintain broad diversification within each asset class to reduce unwanted volatility. This factor is an unfortunate further handicap for mainstream fund managers using active strategies such as market timing and stock picking. Because the success or failure of such strategies is ultimately determined by chance, the gap in relative performance between managers increases during periods of high volatility. This subjects the investor to potentially larger losses if they happen to select an unlucky active manager.

The final conclusion is that investors should hold no illusions. We are now passing through the most challenging market environment in many decades. It is impossible to predict whether near-term returns will be positive or negative. However, research does show that periods of high volatility tend to persist for a period of time. Investors should, therefore, be prepared for continued uncertainty and high volatility, with potentially large bumps in the road for the next few years. The bottom line is that there are no guarantees in the capital markets – recovery will no doubt come, but it is impossible to guarantee that it will come within a short or even an intermediate timeframe.

For the investor with a sufficiently long-term horizon, however, staying the course can offer additional benefits. There may be opportunities to harvest tax losses and manage capital gains, or to reposition a portfolio where the tax cost of realigning holdings was previously too high. Rebalancing a portfolio can also enable investors to buy some shares at low prices precisely because many others are selling. Now more than ever, it is important for investors to stay focused on the long-term to ensure that when recovery does come they are best positioned to capture the benefits.

Lewis Howes is director and co-founder of Fensham Howes Ltd. He can be contacted at lewis.howes@fenshamhowes.com