Equities: The Hangover Part II
Like the American comedy The Hangover Part II, 2011 proved to be a near exact replica of 2010, but with just enough of a different outcome to be considered a different movie.
Just as in 2010, during the first half of the year, investors focused on strong corporate profit growth and upward trending global economic data. As the year progressed, the same actors who triggered risk aversion in late 2010 returned for an encore performance. The lead actor in this act was once again Greece.
There were other events which shook the markets as well, such as the Arab Spring, the Japanese tsunami, subsequent nuclear reactor melt down and the first ever downgrade of US debt. In the end it was the financial stability of Greece which called into the question the viability of the whole European Union.
In short, years of bingeing on cheap debt (relative to borrowing costs pre-EU admission) and covering up the country’s true fiscal position, allowed the Greek Government to fuel excessive public expenditure well above and beyond their means. Recently as Greek borrowing costs soared, it became clear that Greece was not alone and many other PIIGS(1) nations were also in the same boat. With investors punishing the equity markets, European leaders scrambled to find a solution that would quell the markets greatest fear, the breakup of the European Union. Since late November, the combination of credit facilities to backstop EU Sovereign debt and investors waning concern over EU solvency, has seen the markets start to move upward from their greatly oversold condition.
While the S&P 500 finished the year slightly positive, it was certainly a volatile ride. The S&P 500 ended up 2.1% including dividends, besting the Russell 1000 Value (large cap value stocks) index which returned -1.8% for the year. The smaller, higher growth firms of which the Russell 2000 is comprised, returned -4.2% for the year as investors sought the security of larger, dividend paying stocks.
At the epicentre of concern, the European centric MSCI EAFE index fell 12.1% in dollar terms. An extension of these concerns hit the Emerging market stocks (down 20.4% for the year). In sum, 2011 was a very unrewarding year for investors seeking to extract the equity risk premium.
For those with a long-term horizon, valuations look appealing for equity investors. Looking over financial publications, institutional investment surveys, retail aggregate asset allocation and speaking with professional money managers, they all have one thing in common: their unbridled hatred for investing in equities of any flavour moving into 2012.
Frequent readers of our Investment Quarterly will remember our sentiment charts that indicate when too many people are invested one way, the market is unlikely to reward those individuals. Given that capital is a scarce resource that needs to be invested somewhere, all investments are in essence competing for this capital. Based on investor’s risk perception, prices for all investments rise and fall and so does their expected return.
When it comes to equities, a good indicator of relative value can be seen by looking at the expected Equity Risk Premium or more simply, the additional expected return from equities over the risk free rate of return (short term US government T-Bills).
As Figure 1 indicates, rarely has the Equity Risk Premium been this high. In fact the only times when investors have been paid more to own equities over the past 50 years was during the late 1970s and during the 2008 global financial crisis. Investment in equities is certainly not without risk; if there was no risk, the premium would not be this high. The key here is to understand how the current situation might be different from past situations, we are not in the same environment as 2008.
As can be seen in Figure 2 on corporate debt, companies have massively paid down debt and are holding mountains of cash enabling them to better endure economic shocks. Also, many global economic data series are trending upwards, albeit at a slower pace than average, but upwards nonetheless. Risk premiums above the 6% level do not happen very often and certainly do not happen when there is not turmoil in the world.
For those investors willing to lengthen their time horizon when the rest of the investment world is shortening theirs, we believe there may be outsized investment returns to be had.
- Portugal, Ireland, Italy, Greece and Spain
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