THE NEXT BULL MARKET? Still equities
The chorus of investment gurus warning about a major downturn in equity markets grew louder this week when Carl Icahn said stock investors have “a lot to be concerned about it” during an appearance on Fox Business Network.
There’s no doubt he — and anyone else weighing in on the matter recently — have a point. Rising interest rates combined with lofty valuations could easily put the brakes on the current bull run in the U.S., leading to dwindling returns or, worse, a big fat market crash.
But the prospects for equities, despite all the risks associated with them, remain relatively attractive compared with bonds and many other asset classes over the next decade.
Investors certainly need to more prudent about their future stock allocations, but they shouldn’t be even thinking about completely abandoning their positions.
“Equities appear well positioned to offer the best returns of the bunch,” said Savita Subramanian, an equity strategist at Bank of America, in a recent note to clients. “Other asset classes do not look particularly compelling.”
By most accounts, stock returns are expected to be significantly leaner over the next few years. For bond guru Bill Gross, five to six per cent per year is the best-case scenario, and Warren Buffett has said six to seven per cent seems about right.
Both predictions pale in comparison to what equity markets have netted over the past six years, but famed British investor Jeremy Grantham has gone even further in recent months, suggesting that there are not any asset classes currently priced to provide an inflation-adjusted real return of even four per cent annually over the next seven years.
Subramanian’s research leads her to believe the potential long-term return for stocks ranges from five to 12 per cent, which may be on the low end historically at worse, but it’s still better than the likely outcome for other asset classes.
Bonds, which were routed again this week, are expected to suffer the most from rising interest rates and 10-year U.S. treasuries are forecast to climb just two per cent annually over the next 10 years.
Cash is earning close to zero, and while those returns will increase as interest rates rise, Subramanian believes the long-term outlook for short-term interest rates appears quite modest as the U.S. Federal Reserve attempts to normalize rates without causing the economy to falter.
She added that prices for commodities such as oil and gold are less expensive than stocks, but even then, returns over the next decade are expected to be subdued, ranging somewhere between three and seven per cent.
“Home-price forecasts also imply low single-digit appreciation over the next few years and similar growth over longer term horizons as well,” she said. “This is supported by the history of bubbles, which suggests that returns during the subsequent cycle tend to be more muted.”
None of this means investors should just sit and watch as the equity bull run potentially slows to a whimper or worse.
A well-diversified portfolio remains the best remedy for a market correction or crash, but allocations across and within various asset classes should be adjusted to mitigate potential changes.
“Our approach remains unchanged, but we are definitely in the camp that sees restricted upside to long-only approaches to both equities and bonds,” said John Nicola, chief executive at Nicola Wealth Management in Vancouver.
“In both asset classes, we have been hedging and will continue to do that for the most part by using calls and put strategies with some of our equity pools and by having shorter durations on bonds or using alternative debt instruments such as mortgages and high-yield bonds for our fixed-income allocation.”
Nicola is also invested in real estate, mezzanine financing, private equity and other alternative asset classes, leaving the current asset allocation of “regular stocks and bonds” at roughly 40% for the majority of his clients.
Arthur Salzer, chief executive at Northland Wealth Management in Markham, Ont, is also carefully weighing his options these days.
He still sees opportunities in stocks, highlighting European equities in particular, and likes conditions in other areas of the market as well, including U.S. real estate.
At this stage in the interest rate cycle, it’s clear to him that investors need to be very selective about their choices and can no longer rely on broad-based gains across asset classes.
“Active may be the way to go in order to have the prospect of better returns,” he said. “A lot of money has been driven to the indexes and with high P/E ratios and the prospect for interest rates beginning a period of slow increases, beta from many asset classes may no longer be acceptable as expected returns have declined substantially.”
But investors who are nervous about equity markets should be reducing their exposure and bulking up on assets that are uncorrelated to stocks, but not negatively so, said David Kaufman, chief executive at Westcourt Capital Corp. in Toronto.
“Since we don’t know how long the equity bull market will last, investing in something that is negatively correlated can be a bad idea since all it does during the bull market is reduce your returns so you have less in total when the correction inevitably comes,” he said.
The search for “uncorrelated” returns, therefore, is a bit of a holy grail, Kaufman added, especially since a complete market meltdown can hurt everything indiscriminately.
That said, he believes a certain degree of global diversification can help, noting Europe and U.S. stocks have not been highly correlated since the crisis.
Of course, some investors with the means to do so can just “walk out of the casino,” Kaufman said.
“The public markets are not for everyone, and there are many high-quality privateequity and debt offerings that provide income and growth without having to worry about mark-to-market volatility,” he said. “True, these are often far less liquid than public securities, but liquidity is a two-sided coin. Other than people who had leverage, there can’t be anyone who is happy they sold their equities in the depths of the crisis.”
Equities appear well positioned to offer the best returns of the bunch