Assessing Equities After Whirlwind Decade

Some investors believe equity markets are dangerously inflated. Others see strong fundamentals and room for optimism. Who’s right?

An extensive new market outlook report from Principal Global Investors and CREATE-Research finds points of support for both bulls and bears, but warns investors that old assumptions about the equity and bond markets have been severely tested by the “lost decade.”

Report author and CREATE-Research CEO Amin Rajan applies the term “lost decade” to the last 10 to 15 years of market movement—starting with the equity market recession of the early 2000s. Looking back, Rajan notes the year 2000 brought equity markets to “their worst ever point of overvaluation … and then the tech bubble burst spectacularly.” After that, equities entered the “lost decade,” when they were roundly outperformed by bonds, Rajan said.

Add into the mix the worst financial crises since the Great Depression in 2008, which again drove investors away from equities and into lower- and lower-yielding bonds—followed by a subsequent charge back to equity market records by late 2013 and through to today, and the term “whirlwind” indeed seems appropriate. As Rajan observes, investors are happy to have recovered much of what was lost during the 2008/2009 slide, but looking forward, the picture is a lot murkier. Bond yields remain depressed while equities flirt with irrational valuations based on prolonged cheap money policies, at least according to some analysts. What’s an institutional investor to do?

Rajan’s analysis of more than 700 pension plans, sovereign wealth funds, asset managers, retirement plan consultants and other large-scale fund buyers finds there is little interest in turning away from equities—with just 4% of those polled for the research suggesting “the cult of equities is dead.” Rather, the approach for the next year is to get selective about equity exposure, with most favoring North American equity investments (88%), followed by the ex-Japanese Asia regions (81%) and Europe (72%).  

 NEXT: Equities healing or hurting? 

About three in 10 large-scale fund buyers believe the last decade simply saw equities enter a “self-healing phase,” bringing current equity valuations close to where they rationally should be. Another 41% believe this is somewhat likely, but they’re less confident. As Rajan explains, “equities are now favored because bond valuations are at an historic high. A more nuanced view is that equities may have finally healed.”

Despite increasing confidence in equity investment potential, 83% of respondents cited lower and uneven growth in the global economy as a likely headwind for the next decade of investing. Another 55% believe potential fallout from the prospective interest rate hike in the U.S. could derail returns in the short- and mid-term.

Specifically in the case of a U.S.-centric rate hike, Rajan finds investors are “worried about how to price assets in markets addicted to cheap money. They also worry about whether the U.S. economy has reached the escape velocity that finally cuts it loose from the deflationary mindset. Might a premature rate rise start a 1937-style collapse?”

For now, the report finds, investors are still willing to give equities the benefit of the doubt, partly in the belief that “ultra-low rates and deepening recoveries in Europe and Japan will permit an expansion in earnings’ multiples that can sustain current valuations.”

NEXT: Danger in chasing performance 

Accordingly, Rajan says 30% of respondents expect to return more assets to equities, and another two-thirds remain “favorably disposed to equities for one reason or another.” Perhaps overlooking some of their experiences of the past decade, just 28% “expect equities to have a secular re-rating” in the near term, either substantially positive or negative, despite the strong bull run since 2009.

“The reason is simple,” Rajan explains. “Seventy percent of respondents believe that investors chase returns, not asset classes. The emerging pragmatism holds that investing is about making the most of whatever works in the surreal world of near-zero interest rates. Perhaps, the reality of the current equity revival will be best judged not by the inflows when markets are rising, but by their resilience when the inevitable correction comes.”

Looking to the next year, Rajan foresees two potential paths forward. First, he says, the equity risk premium will remain high, volatile and variable “while the idea of a ‘risk-free’ asset is sidelined at today’s bond valuations.” Second, regional equity markets may not move in lock-step while global recovery remains uneven, so geographic selectivity will be critical.

Specific to defined contribution (DC) and defined benefit (DB) plans, the research finds a few important trends continue to take shape. For DB investors, a common plan is to “target a variety of goals via a mix of quality equities, low variance equities, real assets, sovereign bonds and alternative credit.” On the DC side, investors will favor “advice-embedded vehicles to pre-empt members’ herd instinct.”

A full copy of the research can be downloaded here