The Cult of the Equity revisited after 10 years

tyoung

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Back in the day this was a very heated discussion as to whether equities were a special asset class that would outperform other asset classes in the long run.
It's over 10 years since the last posting here but it's worth revisiting

Original thread on The Cult of the Equity

in light of a recent FT piece(it's behind a paywall so I cannot post link).

Barron's has a reply here.
[broken link removed]
and here's a fairly balanced discussion of the topic( by an equity strategist!).
https://ir.citi.com/uABdbFqr9eDTXnRT7m11L4WO4%2Bwono8pBPx18%2BJB2ghRjZ6m9P09vQ%3D%3D
 
Cof E

I question superficial conclusions as to just how 'cheap' equities are given that the 'E' in P/E is on exceptionally high ground - companies have been growing earnings at rates well in excess of general economic growth for several years.

However even if 'E' a good bit lower due to weak economies/de-leveraging etc valuing earnings/dividends by reference to the risk-free rate (whatever that is these days !) would suggest that equities are relatively attractive.

Another reason people should have a core holding in global equities in their portfolios is to give themselves some protection against inflation.....does not seem like a problem now but just wait - allowing inflation to rise is one of the classical ways of dealing with major debt problems. Holding global equities is also a sensible way of protecting wealth against euro break-up which looks increasingly likely.
 
Equities have regressed significantly on the basis of P/E from their overvalued status follwing the tech bubble of 2000.

The P/E of the dow was around 30 times earnings and the Nasdaq around 50 times in 2000. Pure speculative bubble territory. The highest P/Es in history (except the Nikkei's 1990 bubble of 50-100 times).

[broken link removed]


We are now around 15-20 times on the CAPE for the USA market which still signifies overvaluation. The European markets are more tempting on around 10 times the CAPE-
http://valuestockinquisition.files.wordpress.com/2011/09/sg-europe-pe.png

Secular bear markets end on single multiple P/Es. This is what all empirical evidence suggests. Just look at any cyclically adjusted P/E chart and the bottom of each secular bear market is below 10 times.

On this basis the Western indexes (certainly the USA) have further to fall or grind sideways for a number of more years before embarking on a new secular bull market.

Equities were a bad buy in 2000. A much better bet now but further P/E compression should not be ruled out if history is anything to go by, as it usually is.

I am staying defensive. Boring value, large caps with decentish yield that are already on P/Es of below 10. Invest for income for a few more years and hold a large allocation in cash.
 
Hi t

It's very interesting to revisit the discussion of 11 years ago.

My advice in the Guide to Savings and Investments was something along the following lines (I will try to find the actual guide)

Prirorise buying your own home
Reduce your mortgage to a comfortable level ( = your current salary or 50% of the value of your home)
Nothing is risk-free - especially deposits and property (which were generally considered risk free)
Borrowing to invest is risky
Invest in a balanced portfolio of 10 Irish blue chip stocks - their earnings are diversified internationally.
Do not invest more than 20% in banks. From memory, the banks (AIB, BoI and Anglo) formed around 40% of the ISEQ which I thought was too risky.
One can not time the markets.
One can not pick winners - so buy a diversified portfolio of shares.

The ISEQ Overall is down 50%. The Iseq General is down about 17%. The ISEQ financial is effectively wiped out. So an 80% investment in the ISEQ General and 20% in the ISEQ financial would be down around 35%.

"Nothing is risk-free - especially deposits and property (which were generally considered risk free)"
This turned out to be spectacularly correct. Depositors in Anglo and Irish Nationwide should have lost most, if not all of their money. Depositors in the other banks should have lost a chunk of their money. I didn't realise that as a taxpayer, I would be called on to make up their losses.

With the benefit of hindsight, how would I have revised that?

I think I would have been much stronger on "the borrowing to invest" is risky bit. I would say - Don't ever borrow to invest. Pay off your borrowings, including your mortgage, in full before investing.

Cash turned out to be very risky and deposits were only saved by the Government guarantee.

I don't have Irish government bond figures. I presume that would have been a better investment than either Irish equities or Irish deposits.

What would I say now in June 2012?

Nothing is risk-free.
Don't ever borrow to invest
Buying your own home is a good idea for both financial and non-financial reasons. But renting is a viable alternative.
ETFs will give you a good exposure to foreign equities, but they are inefficient from a tax point of view.
You can't time the markets - but from time to time, it does seem that the markets can be hugely overvalued. In retrospect they were back in 2001 as Sea Pigeon pointed out. Presumably they can be hugely undervalued as well, although we haven't had that for many decades.
 
I have found the following in a Word document. I drew the attention of readers to the alternative view critical of the Cult of the Equity.

A diversified stockmarket investment provides the best return and the lowest risk in the long term
Buy about 10 of the top Irish shares and forget about them. You don't need to be an expert, just let the magic of the stockmarket do its work. £10,000 invested in 1971 would be worth £650,000 today or £75,000 in real terms. Expect crashes and slumps along the way, but these are only blips on the path to long term growth.


The CounterView
This blind faith in the stockmarket led to a major debate on Askaboutmoney. In summary, it is argued that the stockmarket has performed so well, that it is now way overvalued. The American stockmarket in particular is still irrationally overvalued and may decline by up to 50% over the coming years. To see this view, have a look at The Great Debates on Askaboutmoney
 
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Sorting stocks by any measure other than common risk factors can lead investors to bad outcomes from investing in equities and many conclude that the last 10 or 11 years have represented a lost decade for equity investors.

In practice it is bad process that is to blame here.

Failure to properly diversify a stock portfolio is the main reason why many investors incurred such large losses in recent years. Irish investors in particular held large positions in a relatively small number of effectively regional banks and a cement company whilst simultaneously gearing up property investments with loans from the same banks.

The market does not reward investors for investing in companies they are familiar with the market rewards investors for taking risks. Since stock specific risk can be diversified the market does not reward investors for taking risks they don't need to take.

Investing directly in Irish companies is free from capital gains tax on death and you can offset capital gains tax losses against profits. True but this is also true of investment trusts which are more diversified and therefore all things being equal are a better investment.

But you also have to factor in the impact of income tax on dividends which are taxed at your marginal rate of tax. A distributing investment fund is only taxed at 30%pa and therefore for a higher rate taxpayer over a long time period the lower income tax rate may be more valuable. There are no absolutes in investing and all investors should take professional advice to determine the best approach for their particular circumstances.

The final consideration is that Irish shares are subject to stamp
Duty brokerage commissions and bid offer spreads. These additional costs should also be considered when making a comparison with an investment fund.

I recently invested in a fund which holds a globally diversified portfolio of 11,000 individual companies and has 15% exposure to emerging markets and 85% to developed markets including Ireland. Think of this as an investment in capitalism inc rather than a bet on the prospects of a tiny number of Irish companies. I don't care where the companies are or what they do or make I don't care what sector they are in.

All i know is that I have far more companies than most people so I am more diversified. I have more small companies and more value companies so I have a higher expected return I have exposure to both developed and emerging markets I am protected by Ucits regulations against fraud, the turnover of the fund is low so that I am not exposed to unnecessary trading costs I can get audited report and accounts so I know that my investment is being run properly and I know that I am paying competive fees and I know that the total expense ratio is 0.67%pa.

What I will never know before the fact is how much I will make. But I have a positive expected return because I am investing in the market rather than gambling on the prospects of a few companies.
 
Hi t

What would I say now in June 2012?

Nothing is risk-free.
Don't ever borrow to invest
Buying your own home is a good idea for both financial and non-financial reasons. But renting is a viable alternative.


Biased in favor of house buying much Brendan ?

The statements above seem contradictory apart from the final one which in my opinion doesn't go far enough. Renting is not only viable , it would be preferable in times of extreme uncertainty.
Buying a house means for most people eliminating diversity and gambling 100% of their savings (and 100% of vastly greater borrowings) on only one asset and not only that but also taking out a crippling loan which limits their ability to emigrate or move in search of employment in an uncertain economy.

Buying your own home could be a good idea for both financial and non financial reasons but it could also be a horrific idea for both financial and non financial reasons. It has certainly been horrific for many people stuck in 100% negative equity for the past 5 years and counting.
 
Buying your own home could be a good idea for both financial and non financial reasons but it could also be a horrific idea for both financial and non financial reasons. It has certainly been horrific for many people stuck in 100% negative equity for the past 5 years and counting.

Hi bullworth. A very good point. I have started a Key Post on the topic, so that we don't take this thread off topic.
 
So, should we write off the stock market? Of course not.

Stocks are priced to earn investors a return commensurate with the risks of owning stocks. Stocks are still more risky than bonds in the sense that the losses will be greater in a bad year.

The higher yield available from stocks compared to bonds does not make them "safer" than bonds. The higher yield is compensation for greater risk.

Of the four pillars of investing;returns,risk,costs and taxes; focus on risk was shown in the landmark study by Brinson Hood and Beebower to account for the lions share of a portfolio return.

If we pick stocks at random the expected return of any stock is about the same as that of the market but with a higher standard deviation. As we add stocks the variation of returns declines.

We also know that for two portfolios with the same average return, the portfolio with the lowest volatility has the highest terminal value.

Therefore a more diversified portfolio is better for investors since taxes are less significant than asset allocation and lower volatility provides higher portfolio values.

QED
 
Another excellent piece on the cult of equity. The writer runs the biggest bond fund in the world and so may have a particular bias.


Much the same discussion we had a decade ago.

"et the 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)? The commonsensical “illogic” of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world! Owners of “shares” using the rather simple “rule of 72” would double their advantage every 24 years and in another century’s time would have 16 times as much as the skeptics who decided to skip class and play hooky from the stock market."

and the conclusion,

"The commonsensical conclusion is clear: If financial assets no longer work for you at a rate far and above the rate of true wealth creation, then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both."

I think the aim of investing now is simply to preserve the purchasing power of your money and this will be much harder than in the past. My bias is towards stocks with an overweight on emerging markets and large cap stocks in developed market.
But I think we'll all be working longer and retiring later.
 
“Stocks for the really long run” would have been a better Siegel book title.

Think that line sums it up. Stocks do very well over the very long term.

Unfortunately the time period is often longer than many people's investment horizon.

We are in a regression stage for stock markets since 2000. The 80s and 90s produced double digit returns on most years. The 60s and 70s pretty much flatlined.

We are back to the flatline decades. Regression to the mean. Always occurs in asset markets. Property, bonds, stocks. Its never different this time.

My approach is to stay global, hold an allocation to emerging and frontier markets, invest in large cap dividend stocks in the West.

Hold gold, silver, commercial bonds and cash and hope for capital preservation as best as possible.

Real stock returns will come from dividends more than capital over the next 5 to 10 years.
 
Lets wind the clock on from the last post of this thread and see how we would have done if we had bought into that particular narrative.

Emerging markets have underperformed developed markets and the frequently quoted "secular bear market" appears to still be in hibernation. Equities generally and global equities for a Euro investor in particular, have had a great couple of years.

Whilst developed large cap stocks have indeed perfomed well in the last few years there have been some notable "dividend stocks" that have had a relatively bad time including IBM, Tesco, BP, Glaxo, Vodaphone. The argument for broad diversification across asset classes is just as strong as ever.

In the bond market, despite frequent descriptions of return free risk, long term government bonds were one of the best performing asset classes last year and bond yields continued to fall resulting in PIMCO having some high profile staff changes. Meanwhile rates of return on cash deposits have also continued to decline.

August 2012 (the last post on this thread) just happened to almost exactly mark the top of the run up in precious metals prices.

So, as it turned out almost everything set out in the last post of this thread was off the mark to a greater or lesser extent.

I don't think it's fair to poke fun at people's tendency to fall for whatever compelling narrative is being peddled by their favourite Guru. But I do think it's fair to point out that if someone is posting on askaboutmoney and making definitive statements about what is going to happen over the next few years - well lets just say, there is a fair chance they are going to be wrong.

JP Morgan, when asked his opinion about what he thought the Stockmarket would do in the future said; "it will fluctuate" that's a prediction I can get behind.
 
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So, as it turned out almost everything set out in the last post of this thread was off the mark to a greater or lesser extent.

Hi Marc,

I don't think that ringledman was that far off the mark. Many who make "definitive statements" tend to say "Buy gold" or "buy bonds", or as I do, "Invest 100% in a portfolio of directly held equities". But ringledman does not make such a definitive statement:

My approach is to stay global, hold an allocation to emerging and frontier markets, invest in large cap dividend stocks in the West.

Hold gold, silver, commercial bonds and cash and hope for capital preservation as best as possible.

He suggests global stocks, which is probably in contrast to those who tend to invest in Irish stocks only. He doesn't specify the proportions of the other assets one should have in one's portfolio. But by recommending equities, commodities, bonds and cash, he was aiming for wealth preservation rather than aiming for the being the top performer, which would have been at the risk of being the worst performer.

I think in retrospect, I would give ringledman 8/10. And to whom would I give 10/10? No one really.
 
Brendan,

To put this into context, i posted after rereading several of his "chicken licken" posts and the whole of this thread.

In isolation you reference one sentence which broadly says;" be diversified". I agree, that is the best approach.

However, you ignore the fact that his interpretation of diversification is skewed (as is yours) to reflect a particular narrative.

His belief that equities were overvalued led him to exclude parts of the market that he didn't like. My point was that it was precisely those parts of the market that he didn't like that have seen the strongest growth. Whereas his selections were almost entirely in those parts of the market that have underperformed.

Consequently, he doesnt meet an objective definition of diversification - he didn't cover all the bases. He took a, in his view, "defensive" position based on a narrative and it turned out that that position relatively to a more inclusive portfolio was wrong. He actually avoided being diversifed. I call this di-worsification.

Adding more of the things to your portfolio that you want (or believe in) is ok to a point, its called tilting your portfolio and makes sense if you add equities at the expense of cash or tilt towards more risky equities, but this doesnt imply that you should be totally excluding those things that you don't like.

To say that his position is better than someone who is saying only buy Irish equities is like attending a meeting of the " flat earth society " and ending up talking to someone who thinks its like a bent playing card, convex but still basically flat. Hey, he would be above average - but still wrong.
 
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Am I the only one whose literary knowledge meant that I had to look up "chicken licken"?

Panic spreading strategy.

from the story where chicken licken panicked all his friends into believing that the sky was falling when actually all it was was an acorn that fell on his head.
 
Hi Marc

I have argued before that you and most others go to a level of diversification which is just not necessary. You often refer to a fund which has 10,000 stocks in it. To me, that is no better than a fund with 100 stocks. ( I would go further and say that it is little better than a portfolio with 20 stocks, but I realise that I am in a minority on that one.)

What does "wrong" mean in this context? I don't think that the bent card analogy is appropriate. They are plain wrong.

The outcome of ringledman's strategy, is at this point in time, performing less well than some other strategies, but much better than the vast majority of strategies especially those who have stayed in cash. Or much better than people who picked a particular share.

You, ringledman and I might agree today that diversification is the best policy, borrowing to invest is unwise, and most of our portfolio should be in equities. So we are in substantial agreement.

You choose 100% equities and an ETF with 10,000 equities in it.
I choose a portfolio of 10 directly held equities in the EU.
ringledman makes an active choice that American equities are overvalued and defensive stocks are undervalued so he puts 50% of his money in these, and buys some commodities and bonds.

I don't think that ringledman is wrong. If we measure the return on his portfolio on 22 February 2025, he may be behind yours, but that does not make him wrong.

It's not right to say that any investment strategy which does not adhere to the Westlake strategy is automatically wrong.

Now I am off to read some kids' books.

Brendan
 
"I choose a portfolio of 10 directly held equities in the EU"........... right away we have Currency Risk and Political EU Risk and its concentrated as its EU.
Then what about Country specific risk followed by the other risks.........Correlation among equities in terms of type of business, where they get most of their income...?

Surely at least 25 - 35 stick with 3%/4% in each?
 
Handbags girls:)

Going right back over a decade to the original Cult of Equity thread I was a leading protagonist of the case that it was a "cult" (not in the Charlie Flanagan meaning of that word:D) and therefore by implication bound to end in tears.

At this vantage point many years later I feel only partly vindicated - it has been a very rough ride but I guess cultists have won out in the end. I now recognise that there is a Bernanke PUT Option. For those unfamiliar with this theory it broadly states that the capitalist authorities and particularly the US will act to restore order to collapsing markets. QE seems to be a spectacular demonstration of that phenomenon. I hasten to add that I do not think this support of the markets is wicked.

As to diversification, well I could rant on forever. Certainly 10,000 is OTT. When going global one should be careful that the diversification really is what you want. Consider a very simple example. Take a European punter choosing between an all European portfolio or between a 50/50 European/Japanese. The latter has in the jargon of MPT less variance (risk) because of diversification but the punter will want to make the following utility call - would a situation where Euro stocks are falling but Japanese stocks are compensating be more of a happy outcome than the reverse i.e. Euro stocks doing well but being dragged down by Japan, be an unhappy outcome.
 
Virtually all academic literature suggests that you need at least 30 stocks to be "diversified".

Re diversification, it's as much about buying companies which themselves deal all over the world (Nestle, Unilever, etc).
 
Just to elaborate on my last point. The great majority of investors do not in fact indulge in global diversification. UK punters greatly favour Footsie. US punters S&P or Nasdaq, Japanese punters the Nikkei (I presume).

This can only partly be explained by currency or local knowledge considerations. People like to keep in line or ahead with developments in their own economy, diversifying into other economies leaves them exposed to falling behind their local peers in a situation where the local economy is outperforming. The obverse is that they outpace their peers when the local economy is underperforming. I believe that the former is more important to investors than the latter and so the unbiased calculus of MPT is not valid for them.
 
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