FINANCIAL markets are taking a breather, and strategists welcome that as a reality check. But quite apart from valuation issues, the upward spike in stock prices since the March lows has elicited much relief as it would appear to signal that the underlying assumptions behind the risks and return of financial assets still hold. Ever since the credit crunch dragged down the value of risk assets almost across the board, the basic tenets of capital markets and portfolio construction have been deeply questioned. Portfolio strategists have been puzzled over the way forward. Is the faith of investors in stocks misplaced? How are retail investors to hedge risks if diversification fails just when it is most needed?
Amidst the numerous studies that appear to confirm the efficacy of stocks as a staple in long-term portfolios, a recent paper by Robert Arnott, former editor of Financial Analysts Journal, presents some startling data. One finding is that there have been long periods in history when stocks underperformed bonds. For instance, between 1979 and 2008, an investor in 20-year Treasuries who consistently rolled over and reinvested in the nearest 20-year bond, beat the S&P500. Second is that the risk premium for equities, which many assume to be 5 per cent, is thin at just 2.5 per cent. This is even lower than that recently calculated by academics Elroy, Dimson and Marsh, who arrived at a long-run risk premium of 3.8 per cent for US equities and 3.4 per cent for world equities.
Of course, the past is not a guide for the future, and some would argue that stocks' long underperformance suggests that the trend will reverse in due course. After all, the alternative of bonds is an uneasy proposition for now: the outlook for long-dated bonds remains murky as the massive stimulus that governments have embarked on does not bode well for inflation. But stocks are no obvious bet either; almost no one expects a return to a Goldilocks era any time soon. Even if the economy does pick up - and signs are that it is stabilising - the credit crisis has sparked a wave of deleveraging and balance sheet restructuring on a massive scale by corporates and individuals. Hence, risk appetites are set to remain restrained. A backdrop of anaemic economic growth also implies muted earnings rises, leaving markets bereft of the fuel of valuation re-ratings and leverage that have underpinned the last few decades.
Investors are thus in a quandary. The only assumption no one disputes is that volatility will remain high. Meanwhile, retail investors have few alternatives but a traditional blend of stocks and bonds, with emphasis on more stable, income-yielding assets. Return expectations will have to be adjusted downwards, and the implications of this will be painful as drawdown rates in retirement will also decline. Yet another challenge will be the need to personally monitor portfolios. Many may be tempted to sit on cash. While that may be comforting in the short run, it is not the best approach to retirement planning.
