Tuesday, March 31, 2009 0 comments

Unlike recent past, stock market unlikely to recover quickly

I get the feeling that many think stock market valuations will improve quickly over the next two or three years. It is doubtful that will be the case. Let me go over the various factors that will be a drag on the market. None of these are earth-shattering views but one should keep them in mind, especially if you are making macro bets or are a newbie, like me, who has a hard time telling when a stock is actually cheap.

Psychology Will Impact Stocks

I have suggested several times that the market may stay weak due to psychological reasons (i.e. people who get burned will largely exit the market; distrust of equities; etc.) If you look at long-term history, you almost always see the stock market overshooting on the downside after major booms. Since the market never hit extremely low valuation levels--even in November of last year--it is possible that market valuations may drop much lower than what many think is possible. (But do note that this doesn't mean that prices will necessarily drop significantly. Instead, it is possible for prices to stay flat for a long time while the economy grows.)

Leverage Is Not Fashionable Anymore

The other reason the stock market won't do as well in the future, and this is a widely acknolwedge point, is that leverage (i.e. usage of debt) will decline in the future. Stocks were getting a big boost from usage of debt. There are less than 10 AAA rated companies in America right now because there is higher leverage than in the past, say 1970's. However, the leverage of American corporations do not seem excessive (the story is different in Europe.) Outside non-financial firms, American corporations did not seem to have relied on excessive debt (but European corporations seem to be more leveraged.)

Even for those companies that don't directly rely on debt to boost shareholder returns, they may be severely impacted because of their customers. The consumer was using leverage so even the lowly-leveraged companies will face difficulties from declining consumer spending, consumer bankruptcies, and so on. Some companies without financial problems that have good balance sheets have been sold off sharply and I suspect it is due to the market marking down future expected returns.

Decline Of Share Buybacks

Share buybacks by corporations are not going to end but it is possible that they will decline (this is a point made by Buttonwood of The Economist as well.) In the last four years (roughly), American corporations bought back $1.73 trillion worth of shares. Such activity is bullish and pushes up stock prices. So if buybacks decline then we will lose the support that was pushing up prices in the last few years.

(There is also a possibility of dividend payouts declining but it's not clear to me if that will happen. This article in The Economist expects dividends to fall but it also points out how companies are reluctant to cut dividends. It is possible, as in 1933, for companies to earn less than they pay out in dividends (i.e. have to issue debt to pay dividends.) It is possible that management will pursue such irrational policies, that incidentally destroy shareholders, in order to placate dividend investors. We have already seen it happen with some banks issuing a ton of shares while paying out dividends. Canadian banks, for instance, have been issuing a ton of preferred shares in order to maintain their dividends (needless to say, a disastrous policy for common shareholders.) In any case, I don't think dividend policy will be a drag on the markets.)

Less Stock Buying By Institutional Investors

It is highly likely that institutional investors will withdraw from the stock markets (i.e. allocate less and less to stocks.) These sources were net buyers in the last few decades and will be smaller buyers in the future.

Insurance companies, for instance, have suffered massive losses on stocks and will likely play it safe from now on. My core holding, Montpelier Re, a reinsurer, suffered unexpectedly large losses last year and I suspect management will ratchet down risk. Governments bonds are richly valued right now so I hope management doesn't overload on them but instead go into corporate bonds, but you just never know what they will do. I suspect other firms are in a similar state, with massive losses on stocks last year, and will contribute less to equities in the future.

The key players that will likely withdraw from the market are pension funds, endowments, and the like. I have already covered stories of massive losses at endowments such as the one at Harvard University, or Caisse de Dupot et Placement, the Quebec pension fund in Canada. Now we get stories of potential losses from Pension Benefit and Guaranty Corporation, the American government's pension agency. All these bodies--these are just the biggest and most famous--will likely ratchet down buying of stocks in the future.

You can get a sense of the shift in asset allocation by pension funds looking at the top two charts in this post. I don't think the pension funds are going to go back to the days of 90%+ in bonds. But I do think we will end up with maybe 50% in bonds (and other fixed income like REITs.)

There is nothing wrong with diversifying into emerging markets or private equity or whatever. As someone who is not a passive investor and hence doesn't believe in so-called wide diversification, the question in my mind is whether these funds are actually lowering risk. No doubt returns will be higher but how about risk? I suspect governments will be stricter in the future and hence this will contribute to less investment in stocks. Unfortunately, this is the worst time to be shifting away from stocks and into bonds, given how government bonds are richly valued and stocks are somewhat attractive. But it's difficult to change policies of these behemoths at the optimal time. Hopefully these funds start increasing their corporate bond exposure rather than government bond exposure.

(In an extreme case--one that I am not predicting--it is possible that governments may force pension funds to invest part of their assets in their own government bonds if they have difficulty issuing bonds. If I'm not mistaken, this is the case in countries like India where the banks are forced to hold Indian government bonds.)


Several factors that boosted stocks, such as usage of debt, will now work in reverse and hurt stock valuations. Furthermore, a lot of parties that provided liquidity to stocks (i.e. engaged in buying and selling stocks) may withdraw, at least partially, from the market. These parties pushed up stock prices in the last two or three decades but will now act as a drag. They will be net sellers over the next decade.


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