A recent article in FT (“Investors wonder if the 60/40 portfolio has a future” 22/09/20) examined a recurring theme, which basically asks if investors must change strategy to earn real returns in the coming years. The article explains:
‘The traditional 60/40 portfolio — the mix of equities and bonds that has been a mainstay of investment strategy for decades — is at risk of becoming obsolete as some investors predict years of underperformance by both its component parts. With stocks and government bonds at historically high valuations, savers are being forced to seek out alternatives, potentially creating a boon for other asset classes but also pitching long-term investors into uncharted territory.’
For some years now variations on this theme have been doing the rounds. Following the introduction of measures such as Quantitative Easing (QE) after the great financial crisis we heard warnings of the new ‘low return environment’. Now as we move into our ‘new normal’ with the further measures introduced to mitigate some of the Covid-19 lockdown fallout, this question has returned.
“It’s like déjà vu all over again” – Yogi Berra
The FT article is written from a US centric view, particularly relating to the (price-earnings) multiples and ‘historically high valuations’ in some markets. Yet when we remove the big technology companies from this equation most markets are still priced well below their pre-Covid highs. An example of this is the FTSE 100 which, at 5849 at time of writing, is down c23% year to date.
Another point, central to arguments such as that in the FT article, is it refers mainly to index investing. Index investing involves use of a ‘tracker’ seeking to replicate entire markets or sectors. With a basic index approach, there will be no identification of mispriced assets or any preference for investing in the emerging companies; those that will be the winners of tomorrow.
Many are mystified by the relatively strong returns in some markets this year. In part this can be explained by the support brought in to mitigate from lockdown. However, another truth about the rise this year is that the stock market is not an index of the entire economy; it is a small subset of companies that have sufficiently appealing prospects to be of interest to institutional money managers.
There are hundreds of thousands of large and, mostly, small companies that are not public. For example, the US business Cargill is a $50 billion+ revenue grain trading company that will never go public. Thousands of cafes, theatres and other entertainment venues won’t go public either. The latter category of companies and their employees are emerging as the main victims of the economic collateral damage from Covid-19. They have been eviscerated by necessary steps to staunch the pandemic.
We should remember that the stock market as described by the legendary investor Benjamin Graham, is a dispassionate ‘weighing machine’ and while the human tragedy is awful, the fact is that many of the lost jobs generate lower than average GDP per person. This aspect of Capitalism is not pretty, and we are seeing the dark side play out. At some point, wider society should have a calm discussion to decide at least how to soften the edges of this system.
The point here is that the stock market is not the economy. It is not the tragic loss of employment of millions. The stock market is a sub-set of generally the most healthy, promising companies in an economy. This does not mean that those healthy companies can forever thrive without a robust foundation in the economy, but if that foundational part of the economy is, say 25% of employment, but only 10% of economic activity, the market can at least remain stable, if not advance.
Without doubt, the changes to our lives and the wider economy from Covid-19 will be reflected in future investment returns. Those with access to the analysis, experience, discipline and reflection of a structured investment process are best placed to remain ahead in the coming years.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” ― Benjamin Graham
Barra Gorman FPFS
Chartered Financial Planner