The Endgame Part II

In our last post we wrote about the potential long term effects of deleveraging the world. These include slow growth, lower living standards and defaults. Despite the negative potential for the economy, stocks won’t necessarily follow suit. Why would the stock outlook be rosier than the economic outlook? Here are a few reasons:

  • First is price. We believe that the most important determinant of future return of an asset is its price today. “Cheap” today can translate to high rewards later. On the other hand, buy an asset at a high price, such as real estate in 2007, and it will either do nothing for years (best case), or crater (worst case) until its price comes in line with historical norms. The S&P 500 is up just 4.8% per year for the last fifteen years despite growing earnings and dividends, and reduced debt levels at companies. That is just about half the long term return since 1926. There’s a firestorm of controversy right now about whether this makes stocks cheap, but keep in mind that over this same time frame international and small cap stocks performed far better than the S&P 500. You don’t need to own the S&P to succeed with stocks.
  • Second, companies have become more diversified in the last twenty years, largely by increasing their sales and manufacturing ranges to include most of the world. This diversification has helped mitigate earnings fluctuations normally caused by business cycle behavior. As a corollary, companies have learned to manage costs, inventories, and cash far better than in the past. This, too, has helped dampen volatility in earnings streams. Essentially, companies are managing themselves far better than many governments.
  • The general popularity of stocks has plummeted. Global pension fund allocations to stocks dropped from 49% to 41% from 1995-2011. That might not sound dramatic, but given that the pension fund assets in question total $27.5 trillion, that’s a lot of bucks. Personal ownership of stocks in 401k accounts has fallen to the lowest level since Gallup began tracking the numbers, at 54%. See here for the data. When equities fall out of favor, that tends to be a good sign for future returns because the population of potential buyers increases.

Exactly when these factors will kick into gear to generate higher stock returns is a big unknown. But each of these factors is contributing to a scenario that will eventually cause a bull market, and in the meantime will at least support stock levels in the trading range that we’ve been experiencing for lo these many years.