Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared yesterday, June 25, 2012.
The Financial Times published an article last May about the end of the cult of equities. If you are a member of the equities cult, you believe that an investment in equities will provide a superior risk-adjusted return in the long term relative to bonds. Even though risk may be greater, the equity risk premium (equity returns minus bond returns) will more than compensate for the additional risk. Equity returns come from two sources, dividends and capital appreciation. While dividend yields were low by historical standards, investors believed that most equity returns would come from capital appreciation.
Because equities are riskier than investment-grade bonds, for decades dividend yields exceeded bond yields. That all changed in 1956 when 10-year U.S. Treasury bond yields exceeded equity dividend yields for the first time in the U.S. going back a century. Bond yields exceeded dividend yields from 1956 to 2011-2012 when the relationship reversed after more than half a century. Recently the S&P 500 dividend yield was 2.2 percent versus the 10-year bond yield of 1.6 percent.
So the cult of equities started in the 1950s and certainly accelerated in the 1980s and 1990s as equities became the asset class of choice for institutional investors such as pension funds and endowment funds and individual investors through direct ownership of equities or indirectly through mutual funds, which grew rapidly during this period. Individual equity exposure also increased through their pension plans.
What started the cult of equities? One word: performance. From the beginning of 1950 to the end of 1955, equities, as represented by the S&P 500, provided annual returns of 25.2 percent versus 1 percent for long-term corporate and government bonds. As a legacy of WWII, the Federal Reserve, much like today, had suppressed long-term interest rates until 1950. As long-term interest rates rose, bond prices declined and annual returns were minuscule and less than inflation. As the stock market crash of 1929 and the Great Depression became distant and faded memories, the appetite for equities increased.
Equities continued to outperform bonds from 1956 for the rest of the 20th century, although bonds did as well as equities in the 1970s. From 1956 to the end of 1999, equities provided annual returns of 10.4 percent versus 6.0 percent for long-term corporate and government bonds. Inflation ran about 4.7 percent annually during this period, so real (inflation adjusted) returns were lower.
So what has caused investors to lose their appetite for equities? Again, one word: performance. The first decade of this century experienced two devastating bear markets in which investors lost at least half of their stock market wealth. The first bear market was a result of the dot.com bubble and an overvaluation of stocks in general. The S&P 500 peaked at 1527 in March 2000 and hit bottom at 777 in October 2002, a decline of -49.1 percent. Five years later, the S&P 500 hit a new peak of 1565 before it started a dramatic decline of 56.8 percent to 677 in March 2009. This was the worst bear market since 1929 and the first since then to have been caused by a financial crisis from the collapsing of credit and housing bubbles.
The end result has been an ugly first 11 years in this century for equities. From 2000 to 2010, the S&P 500 had an annual return of only 0.4 percent versus annual returns of 8.0 percent for long-term corporate and government bonds. Given annual inflation of 2.4 percent during this 11-year period, real returns were negative for the first time since the 1970s. Today the S&P 500 is still well below its March 2000 peak.
In addition to mediocre equity returns since 2000, equity volatility has also been at historic highs. The combination of low returns (negative real returns) and higher risk has been the primary factor for increasing investor risk aversion and decreasing appetite for equities. But not the only one. Other factors would include the financial crisis and the Eurozone crisis, increasing economic uncertainty, increased globalization, regulatory reform in the financial sector, tax rules favoring bonds over equities, high-frequency trading and the flash crash in 2010, less liquidity in the market and the growth of government debt and deficits. So institutional and individual investors have reallocated billions of dollars from equities to bonds and other financial assets since the financial crisis of 2008-2009.
In addition to investors losing interest in equities, corporations have also been reducing equity in their capital structure by repurchasing stocks, and raising billions of dollars in the bond markets, whether needed or not, because of historically low interest rates. The implications of the de-equitization of the financial system can be serious. Equity is the risk capital in a financial system and the absorber of economic shocks. Less equity will result in a more volatile economic system. Plus emerging companies usually publicly access the capital markets first in raising equity capital via an Initial Public Offering (IPO). Despite the publicity, good and bad, associated with the Facebook IPO, fewer companies are going public, annual average of 130 since 2001 versus 503 in the 1990s, which could eventually have a major impact on economic growth. And investors have fewer choices today; the number of publicly traded companies has declined since 2000.
What should equity investors do going forward? If you are a contrarian or value investor, the Financial Times article could be good news. Many remember the BusinessWeek article in 1979 titled “The Death of Equities.” The 1970s were not a good decade for equities or bonds. Nominal equity returns were 5.9 percent annually, similar to long-term bonds, but inflation was 7.4 percent, so real return were negative for both bonds and stocks. The BusinessWeek article was widely quoted and publicized, but after the 1981-82 recession, the stock market enjoyed returns of 18.5 percent annually from 1982-1999, one of the best periods in stock market history. The media have a long history of bad-timing articles, perhaps this time also. A 1950s scenario of raising interest rates may benefit equities relative to bonds.
Investing in equities always involves uncertainty. There have been many unexpected events since 2000 impacting equity returns in a negative way: the dot.com, credit and housing bubbles; two recessions, one severe; the financial crisis; the Eurozone crisis; and acts of terrorism and wars, to mention a few. Hopefully there will be fewer such events in the future and investors will regain their appetite for equities. Equities are one of the few ways in which investors can participate in the economic growth of companies and countries. A healthy equities market in which investors have confidence is important for the economy.
Old cults never die, they just fade away for a while; maybe the cult of equities is just lying dormant like in the 1970s, ready to spring back to life after a couple of years. Long live equities.