The Long Good Buy
The Long Good Buy

The Long Good Buy

Equities are on the riskier side of the investment range because equity investors have the last claim over a company's profits (after bond holders and other creditors). (LocationĀ 1198)

For investors in fixed income assets (the income is known in nominal terms at the time of purchase), the risk is one of government or corporate default; (LocationĀ 1201)

Specifically, they found that between 1889 and 1978 the average real return on stocks was approximately 7% per year (in the US), and the rate of return on government bonds was just below 1%. (LocationĀ 1214)

Reinvesting dividends is one of the most powerful and reliable ways to grow wealth over the long term. Since the early 1970s, roughly 75% of the total return of the S&P 500 can be attributed to reinvested dividends and the power of compounding. (LocationĀ 1250)

In general, we can say that equity markets perform best when economic conditions have been weak, valuations are low, but there is an improvement in the second derivative of growth (LocationĀ 1287)

that is to say, the rate of change stops deteriorating. And equity markets suffer when valuations are high and/or concerns over growth start to be priced late in the cycle when the second derivative of growth starts to deteriorate. (LocationĀ 1288)

One simple way is to use the real yield gap in the US (the difference between the dividend yield and the real bond yield) as a proxy. (LocationĀ 1405)

the end of the hope phase roughly coincides with the peak of the trailing P/E multiple (maximum positive sentiment about future growth). (LocationĀ 1477)

the best time to buy into the equity market is usually when economic conditions are weak and after the equity market has fallen, but when the first signs start to emerge that economic conditions are no longer deteriorating at a faster pace. (LocationĀ 1481)

Although earnings growth is what fuels equity market performance over the very long run, most of the earnings growth is not paid for when it occurs but rather when it is correctly anticipated by investors in the hope phase and when investors become overly optimistic about the potential for future growth during the optimism phase. (LocationĀ 1488)

There is also a link between the cycle and valuations. Using simple valuation metrics such as the P/E ratio, valuations tend to fall in the despair phase and rise sharply in the hope phase as expectations about a future profit recovery push up prices in anticipation of the recovery actually materialising. (LocationĀ 1504)

The highest annualised returns (the average return that an investor would have achieved over a specific period of time if the return were compounded at an annual rate) occur during the hope phase. In the case of the US and Europe, the return in this phase has averaged between 40% and 50% (with total price appreciation in real terms annualising at over 60% in the case of the US). (LocationĀ 1534)

whereas in both cases profits are still falling during the hope phase, when much of the return in the market is actually realised. (LocationĀ 1541)

Generally speaking, returns are higher if bond yields are falling, and this is the case in all phases of the industrial cycle. (LocationĀ 1700)

During late-cycle periods that are accompanied by rising inflation, bonds are usually less good diversifiers for risky assets, and equity/bond correlations have often increased alongside rising oil prices. (LocationĀ 1757)

What is perhaps more surprising is quite how large the potential is for outperformance by diversifying into other asset classes at this point in the cycle. (LocationĀ 1767)

In the hope phase, equities tend to offer by far the best returns, with a clear ranking of the asset classes. (LocationĀ 1771)

Bonds and equities, which are more forward-looking assets, see a larger part of their returns during the hope phase, whereas commodities (which are driven by the supply and demand balance rather than expectations) are the first to perform well when the earnings growth is (LocationĀ 1866)

realised and actual growth (rather than anticipated growth) is reflected in stronger demand. (LocationĀ 1867)

In these circumstances, a fixed nominal return is highly prized, whereas equities ā€“ whose cash flows and dividends would fall in line with inflation ā€“ are more exposed and require a higher prospective return (lower valuation or higher ERP) to compensate for the risk. This is why in economies that are more prone to deflation, such as Japan and (more recently) Europe, rising interest rates and bond yields have often been seen as positive for equity investors. (LocationĀ 1905)

Quite often, the sharpest rise in bond yields is from the trough of the economic cycle. (LocationĀ 1936)

He argued the merits of investing in equities to generate inflation-linked growth for pension funds. He became famous for allocating the entirety of the pension fund's investments to equities, a move that is often associated with the start of the so-called cult of the equity. (LocationĀ 2082)

The more you examine the equity market at a micro level (that is, the more you look at individual companies or groups of companies rather than the broad equity market index), the more likely it is that returns will be affected by idiosyncratic issues, such as the specifics of a company or industry, the regulatory environment, issues related to competition, such as mergers and acquisitions, and so on. (LocationĀ 2132)

This issue of consistency is even more evident when it comes to looking at the performance of sectors within the market, or patterns of performance across industries. (LocationĀ 2137)

Equally, their sensitivity to economic conditions can change over time. For example, historically the chemical industry has been considered cyclical, in that its revenues are highly influenced by the economic cycle. (LocationĀ 2139)

But the examples above cannot be always relied on. For instance, large parts of the chemical industry have changed their business mix in recent years to higher value products such as coatings, adhesives, cleaning materials and agrichemicals (fertilisers and pesticides), for which final demand is likely to be more stable. (LocationĀ 2149)

The point of these examples is not to say that there are no discernible patterns over time but merely that an investor should recognise that relationships between parts of the stock market and macro factors are subject to change over time as the drivers and competitive developments within and across industries can also change. (LocationĀ 2158)

I find it quite useful to place industries and sectors of the stock market into four groups according to sensitivity and valuation. (LocationĀ 2165)

The hope phase, as expected, is the best period for cyclical companies relative to defensive ones, with a median outperformance of 25%. (LocationĀ 2242)

By splitting industries into cyclical and defensive groups, based on their GDP sensitivity, we can see that there is a close relationship over time between the relative performance of the two groups and the level of these indices. (LocationĀ 2252)

However, investors are sensitive not just to the level of these indicators but also to the rate of change; (LocationĀ 2276)

In reality, therefore, there is a complex interplay between the cycle measured as the level of growth and its direction of travel (is it improving or deteriorating?), and between whether bond yields are increasing or decreasing. There are many permutations. (LocationĀ 2281)

The best combination, as shown for the market as a whole in chapter 3, is during a recovery ā€“ when the economy is still in recession, but the rate of growth is inflecting upwards, or starting to look less weak. (LocationĀ 2286)

At the other extreme ā€“ where the PMI is below 50 (the economy is probably in recession) but rising from a trough level just as bond yields are rising ā€“ the pattern of leadership in the market reverses. (LocationĀ 2301)

the relationship between so-called value and growth companies is somewhat less straightforward because these definitions tend to cut across companies in different industries. (LocationĀ 2305)

In general, growth refers to companies that enjoy more stable or higher growth in revenues over time and that tend to trade at higher valuations. (LocationĀ 2306)

albeit not very strong, relationship. Stronger economic growth is usually associated with better performance of value (cheap) stocks because these are often more cyclical in terms of sensitivity. (LocationĀ 2320)

In this final part of the investment cycle, when investors tend to be most confident, they allow valuations to increase in equity markets even as profit growth slows. It is this environment where growth stocks typically have their strongest relative returns. (LocationĀ 2326)

Although exhibit 5.7 shows average returns through different phases, a clearer pattern becomes visible when we look at the relative performance over time, which tends to show a fairly persistent longer-term trend of value outperforming. (LocationĀ 2359)

A more important driver of the relative performance between value and growth is their respective relationship with interest rates and bond yields, typically described as their ā€˜durationā€™. (LocationĀ 2368)

Similar to bond duration, equity duration relates to the length of time until investors expect to receive future cash flows from their investment in a company's shares; hence, in this sense, duration is a measure of the company's cash-flow maturity and, therefore, interest rate sensitivity. (LocationĀ 2371)

A good example is a technology company, or the whole technology sector, where companies are investing rapidly for future growth and likely pay no dividends as they do (LocationĀ 2374)

Long-duration stocks will see their net present value rise more for any given fall in interest rates than a shorter-duration company, and vice versa. (LocationĀ 2376)

There has been a significant change in the relationship between bond yields and the relative performance of growth and value over time. (LocationĀ 2378)

The period between 2000 and the start of the financial crisis in 2007 was one in which the value premium reasserted itself. (LocationĀ 2395)

Since the global financial crisis of 2007, the relationship seems to have reversed once again, with lower bond yields associated with weaker performance in value stocks relative to growth stocks. (LocationĀ 2398)

Given the higher risk premium, investors have also increasingly valued the stability or predictability of a company's returns over time. (LocationĀ 2415)

This is why in the post-financial-crisis cycle, ā€˜bond-likeā€™ equities such as infrastructure companies and government-backed concessions (for example, some toll roads or utilities that have a fixed contract or an inflation-protected return on capital) have also performed strongly. (LocationĀ 2419)

Other styles or factors within the market, such as large versus small capitalisation or specific stock performance, tend to be even less consistent over time and across cycles, (LocationĀ 2427)

Bear markets are a natural, or even inevitable, part of an investment cycle. (LocationĀ 2449)

For example, equity investors have, on average, lost about the same amount in the first three months of a bear market as they would have earned in the final months of a bull market. (LocationĀ 2455)

Equity prices shift downwards to adjust to a fall in future growth expectations. Just as rising rates tend to trigger a bear market, it often takes a period of interest rate cuts to reverse the process and raise the value of future cash flows. In this way, most bear markets and bull markets are usually, at least in part, a monetary phenomenon. (LocationĀ 2462)

In reality, the triggers, timing and profile of recovery vary significantly, and bear markets come in many shapes and sizes. (LocationĀ 2466)

Most bear markets are relatively short, lasting about 2 years. However, others are much more drawn out, and the duration from peak to trough may be significantly longer and the decline deeper. The difference often relates to the nature of the economic cycle and the interplay between this cycle and other factors. (LocationĀ 2468)

It is not uncommon for market volatility to rise towards the end of a bear market and for a sharp recovery to revert to a decline shortly afterwards. (LocationĀ 2475)

Looking back through history, we can see many examples of deep bear markets that had a volatile and slow recovery. In the UK, for example, a stock market peak was achieved in 1825. (LocationĀ 2477)

The 1973/1974 bear market is a case in point. A strong initial bounce from a sharp fall is little comfort to an investor who bought close to the top. (LocationĀ 2489)

Of the nine bear markets over this period, six were followed by recessions. The others were more a function of political events or other triggers. (LocationĀ 2492)

Over time, most bear markets are a function of one (and sometimes a combination) of three triggers: (LocationĀ 2535)

Rising interest rates and/or inflation expectations together with fear of recession. (LocationĀ 2536)

An exogenous and unexpected shock that increases uncertainty and pushes down stock prices (as the required risk premium rises). (LocationĀ 2537)

The bursting of a major asset price bubble and/or the unwinding of structural imbalances that result in deleveraging and often a banking crisis. (LocationĀ 2538)

Cyclical bear. Typically a function of rising interest rates, impending recessions and expected falls in profits. These markets are a function of a typical economic cycle and are the most common type of bear market. (LocationĀ 2543)

Event-driven bear. Triggered by a one-off shock that does not necessarily lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation), but which leads to a (LocationĀ 2545)

short-lived rise in uncertainty and pushes up the equity risk premium (the required rate of return). (LocationĀ 2546)

Structural bear. Usually triggered by the unwinding of structural imbalances and financial bubbles. Often a price shock, such as deflation, follows. This tends to be the deepest and longest type of bear market. (LocationĀ 2547)

Bear markets that have been described as cyclical are those that relate to a standard economic downturn triggered by a period of tighter monetary policy. (LocationĀ 2699)

Overall, therefore, we can broadly describe cyclical bear markets as a monetary phenomenon that generally reaches a trough in prices 3 to 6 months after the first rate cut. (LocationĀ 2705)

Taking the history of these types of bear markets together shows us that the average cyclical bear market experiences a fall of about 30% and lasts for about 27 months. (LocationĀ 2712)

Structural bear markets are usually the result of some kind of misallocation of resources. (LocationĀ 2767)

Generally speaking, economic imbalances usually take a long time to unwind. Savings rates need to rise as cash flows are used to rebuild balance sheets. (LocationĀ 2783)

Many of the structural bear markets in the past have been preceded by very low interest rates and inflation: a factor that helped the boom in investment and strength in equity prices in the first place. (LocationĀ 2798)

As a consequence, structural bear markets do not typically end until future returns on capital rise sufficiently to boost investment. (LocationĀ 2804)

On average, interest rates fell more sharply during structural crises than during cyclical ones, particularly in the US. Although interest rates have fallen on average by about one-third in cyclical bear markets, they have fallen by 70% on average in the structural ones. (LocationĀ 2809)

Another key factor that seems to be common during structural bear markets is a price shock, either inflationary or deflationary. More often than not, it is deflation. (LocationĀ 2873)

Not only does the bubble period and subsequent collapse tend to centre on a narrow number of stocks, but also markets overall tend to be highly volatile. (LocationĀ 2903)

One of the key features of structural bear markets is high volatility during the period of price declines and during the recovery. (LocationĀ 2904)

Also, the decline in earnings (that the market anticipates) often continues after the market reaches a trough. (LocationĀ 2914)

Removing event-driven bear markets and looking at the entire decline of the bear market (taking into account that the precise timing of the EPS decline differs in each cycle) results in an average EPS fall of 19%. (LocationĀ 2999)

This suggests that equity bear markets (excluding event-driven ones) are largely about falls in profits or earnings per share, although valuations typically fall in bear markets. (LocationĀ 3002)

The experience in a bull market is very much the reverse, where the hope phase is characterised by strong valuation expansion as equity prices start to rise in anticipation of future profit growth in a period when actual profits remain depressed. (LocationĀ 3004)

Put another way, prices start to fall 5 months before EPS does. However, the range is wide. (LocationĀ 3007)

Cyclical and event-driven bear markets generally see price falls of about 30%, whereas structural ones see much larger falls, of about 50%. (LocationĀ 3012)

Event-driven bear markets tend to be the shortest, lasting an average of 7 months; cyclical bear markets last an average of 27 months; and structural bear markets last an average of 4 years. (LocationĀ 3014)

Event-driven and cyclical bear markets tend to revert to their previous market highs after about 1 year, and structural bear markets (LocationĀ 3053)

take an average of 10 years to return to previous highs. (LocationĀ 3054)

The 2007 financial crisis and bear market could be described as a typical structural bear market but the response to it in terms of policy was unique (perhaps because policymakers were intent on avoiding the mistakes of the past). (LocationĀ 3059)

What really sets the 2007ā€“2009 bear market apart from other structural bear markets is the policy response. The rapid cuts in interest rates and adoption of QE resulted in a sharper rebound in equity (as well as other financial asset) prices than we have seen in the past. (LocationĀ 3064)

The fact that several indicators of data may have moved prior to one or two bear markets in the past does not mean they can be relied on to do so again; (LocationĀ 3075)

The reliability of indicators, therefore, tends to be low, and there are generally many false negatives and necessary, but not sufficient, conditions for a bear market to evolve. (LocationĀ 3077)

Most important, because equity prices themselves anticipate the future, it is difficult to find anything that leads equity prices. (LocationĀ 3081)

Perhaps unsurprisingly (or it would be too easy for investors), most of the variables could be dismissed because they were unreliable; they either showed no consistent pattern of behaviour prior to a bear market, or they lagged the movements in the equity market itself, or the variables were too volatile to rely on. (LocationĀ 3091)

The most common features of bear markets are some combination of deteriorating growth momentum and policy tightening at a time of high valuation. (LocationĀ 3100)

there are a small number of variables that, in combination, tend to move in a particular way in the build-up to a bear market. (LocationĀ 3102)

At the very least, in combination they may provide valuable information after (LocationĀ 3104)

the peak of the market on whether a bear market bounce is genuinely the start of a bigger fall rather than a shorter correction. (LocationĀ 3105)

Rising unemployment tends to be a good indicator of recession, particularly in the United States: unemployment has risen prior to every post-war recession in the (LocationĀ 3106)

But very low unemployment does appear to be a consistent feature prior to most bear markets. Combining periods when unemployment has hit a low at a time when equity valuation is particularly high provides quite a useful signal of potential risk in the stock market: (LocationĀ 3108)

Rising inflation has been an important contributor in past recessions and, by association, bear markets, because rising inflation tends to tighten monetary policy. (LocationĀ 3111)

Related to the point about inflation, tighter monetary policy often leads to a flattening, or even inverted, yield curve. Because many, although by no means all, bear markets are preceded by periods of monetary policy tightening, we find that flat yield curves, prior to inversion, are also followed by low returns or bear markets. (LocationĀ 3118)

As a consequence, we use the 3-month to 10-year measure, with a focus on the short end of the yield curve (0ā€“6 quarter). (LocationĀ 3122)

Consistent with Fed research, we find that the near-term 0ā€“6 quarter forward spread has also been a somewhat more significant predictor of recession risk than, for instance, the 3m10y measure. (LocationĀ 3124)

The highest (LocationĀ 3130)

returns are when the ISM is low but recovering, and the lowest are when it is low and deteriorating. (LocationĀ 3130)

High valuations are a feature of most bear market periods. Valuation is rarely the trigger for a market fall; often valuations can be high for a long period before a correction or bear market. (LocationĀ 3142)

In this measure we calculate the financial balance as total income minus total spending of all households and firms as a measure of financial overheating risk. (LocationĀ 3145)

Although no single indicator is reliable on its own, the combination of these six seems to provide a reasonable signal for future bear market risk. (LocationĀ 3151)

All of these variables are related. Tight labour markets are typically associated with higher inflation expectations. These, in turn, tend to tighten policy and weaken expectations of future growth. High valuations, at the same time, leave equities vulnerable to derating if growth expectations deteriorate or the discount rate rises, or, worse still, both of these occur together. (LocationĀ 3152)

But just as bear markets can vary in length and strength, so can bull markets. Some are extremely long and strong, exhibiting a sustained secular trend, often with rising valuations. Others can be relatively flat or trendless, where much of the return comes from the dividend or earnings growth. (LocationĀ 3192)

Equity investors expect to enjoy a higher return on equities (given their risk and the uncertainty of future returns) than they would expect from a less risky asset such as a government bond (where the return is preknown in nominal terms). (LocationĀ 3196)

Just as within an equity cycle itself, where much of the return comes in a short burst in the hope phase, the longer-term upward trend in equity prices also tends to come in phases. (LocationĀ 3200)

Although the economic environment was conducive to strong returns in the equity markets in this period, valuations also recovered from their post-war levels aided by a secular decline in the equity risk premium as many of the risks to the global system faded. (LocationĀ 3220)

Academics have focused on the fall in inflation as one of the key drivers of this secular bull market post 1982. In particular, some have argued that investors suffered from ā€˜money illusionā€™ after the great inflation of the 1970s. This resulted in two errors: first, investors capitalised future earnings at the then (very high) nominal rate rather than the real rate and, second, they failed to take account of the gains that were generated by depreciating the real value of nominal liabilities. (LocationĀ 3257)

Between 2007 and 2010, the median wealth of a household in the United States fell 44%, resulting in levels falling below those of 1969.8 (LocationĀ 3300)

But, even when we look at the ā€˜typicalā€™ equity cycle, issues of definition emerge. For example, the latest equity bull market that started after the financial crisis in 2009 could be considered ongoing, or could be said to have ended in October 2018, when the market fell by close to 20% (a typical definition of a bear market) before rapidly recovering. (LocationĀ 3310)

The average bull market has experienced annualised returns of 25%. (LocationĀ 3321)

Annualised returns vary from 17% to 42%. Generally, the highest annualised returns come after the deepest bear markets. (LocationĀ 3322)

On average, in past bull markets 75% of the total returns on equities has come from price and 25% from reinvested dividends. The proportion from dividends ranges from 16% to 46% (LocationĀ 3323)

Bull markets also vary in terms of their composition ā€“ that is to say, what drives them. Returns to equity investors can come from price changes (driven by earnings) and from valuation changes, because the multiple (for example, the P/E ratio) that investors are prepared to pay for expected future earnings can change. (LocationĀ 3428)

So when we think about bull markets, it is not just the length and strength that is relevant to investors but also the difference between the price return and the total return. (LocationĀ 3434)

In addition to the long-term structural uptrends, and the more typical cyclical bull markets, there are periods of relatively flat returns. (LocationĀ 3443)

Skinny and flat markets (low volatility, low returns). Flat markets where equity prices are stuck in a narrow trading range and experience low volatility. (LocationĀ 3446)

Fat and flat markets (high volatility, low returns). Periods (often quite long) when equity indices make very little aggregate progress but experience high volatility with strong rallies and corrections (or even mini bull and bear markets) in between. (LocationĀ 3448)

the stock market in the US has been in one of these phases about 20% of the time since 1945 (in the case of Europe, over the same period these types of market environment look a bit more common and account for some 30% of the time; the difference is probably explained by the fact that the US equity market has generally had stronger profit growth, which has driven the market higher). (LocationĀ 3459)

They have tended to be relatively short, lasting 1ā€“3 years. (LocationĀ 3529)

Often economic growth is strong in these periods, averaging 3%ā€“4%. Hence, earnings are usually strong, causing a 10ā€“15% derating in these low return environments. (LocationĀ 3530)

Last, on average, although interest rates are rising during these flattish periods, strong earnings growth helps to buffer the higher rates and falling valuations; hence, the market hovers rather than falls. (LocationĀ 3531)

When financial bubbles burst they can be the cause of severe structural bear markets, often with devastating consequences for both broader asset markets and economies. (LocationĀ 3560)

Although bubbles can be concentrated in a single industry or asset class, and do not always spread out to a broader structural bear market, others can be quite broad-based, with an impact across the whole market and beyond. (LocationĀ 3561)

A reasonable working definition might be a rapid acceleration in prices and valuations that makes an unrealistic claim on future growth and returns. (LocationĀ 3570)

The second part of this definition is important because not all strong rises in prices necessarily result in bubbles. (LocationĀ 3571)

As confidence in the theme or asset increases, valuations rise to levels that cannot be matched by future returns. (LocationĀ 3574)

In his comprehensive study of the early bubbles of the 17th and 18th century, Charles Mackay (1841) asserted that ā€˜men ā€¦ think in herds; it will be seen that they go mad in herds, while they recover their senses slowly, one by oneā€™. (LocationĀ 3577)

Shiller describes a bubble as ā€˜a situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bring in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of othersā€™ successes and partly through a gambler's excitementā€™. (LocationĀ 3580)

The tendency for excitement about a theme to drive investors into a market with little regard for the valuations paid, or the returns implied by these valuations, is one of the most important hallmarks of a developing bubble. (LocationĀ 3584)

When reviewing these bubbles, and their eventual collapse, there are some common threads and characteristics that link them even though they originated in an array of different industries and under very different circumstances. (LocationĀ 3598)

One of the most important features of bubbles in financial assets is the spectacular and often rapid appreciation of prices and valuations that occurs during the bubble, which generates valuations that ultimately overstate the likely possible future returns. (LocationĀ 3606)

Although the breadth and impact of the tulip mania has since been questioned (see Thompson 2007) it was, nonetheless, a boom of historic proportions. (LocationĀ 3612)

At the height of the boom in 1636 and early 1637, when demand was at its highest, the bulbs themselves were still in the ground and could not be physically delivered until the following spring. Financial innovation played a part in driving prices ever higher. A futures market in bulbs developed that enabled sellers to sell forward tulips at a given price for a particular quality and weight. (LocationĀ 3618)

The risks compounded when most of these contracts were paid for by credit notes, making the system vulnerable to collapse and, eventually, contagion. (LocationĀ 3621)

Despite the experience of the British railway bubble, a similar pattern was repeated in the US just a couple of decades later. The scale of the collapse in prices and investment in its wake was so devastating that it led to a huge structural bear market (LocationĀ 3636)

and economic downturn that became known as the ā€˜Long Depressionā€™ and was the worst economic downturns until the Great Depression of the 1930s. (LocationĀ 3638)

The structural bear market that followed was so severe that the index failed to recover to its previous peak until November 1954 (Ferguson 2005). (LocationĀ 3645)

Of course, noting spectacular price increases and collapses is only of interest if there is a common cause, similar characteristics or recognisable patterns of behaviour that can help investors to spot similarities in the future. (LocationĀ 3678)

Looking at history, one of the most important components and characteristics of bubbles, aside from their price ascent and subsequent decline, is the belief that something has changed, usually a new technology, innovation or growth opportunity. (LocationĀ 3679)

A recent study by data scientists found that, in a sample of 51 major innovations introduced between 1825 and 2000, bubbles in equity prices were evident in 73% of the cases. (LocationĀ 3685)

They also found that the magnitude of these bubbles increases with the radicalness of innovations, with their potential to generate indirect network effects and with their public visibility at the time of commercialisation.12 (LocationĀ 3686)

Although these bubbles involved frenzied speculation and price rises in the shares of the companies involved, and may appear no more rational than the tulip mania a century earlier, more recent interpretations have suggested that innovations and new technologies did play a part in their development. (LocationĀ 3691)

These companies in return had the exclusive rights to exploit resources (such as tobacco and the slave trade), thereby opening up the possibilities of super-normal profits. (LocationĀ 3697)

The next big wave of technology came with the railway age of the 1840s in the UK and, with it, the next great bubble. (LocationĀ 3715)

Many high-profile celebrities and politicians became investors in the railway stocks. (LocationĀ 3720)

This breadth of interest had led more people to believe in the ā€˜sure betā€™ of the investment. In 1845 an author known as ā€˜successful operatorā€™ wrote, ā€˜A short and sure guide to railroad speculation ā€“ a few plain rules how to speculate with safety and profit in railway sharesā€™. (LocationĀ 3725)

Similar to the technology bubble that came about a century and a half later, investors correctly identified the transformational impact of the latest innovations but ultimately overstated the potential returns that such innovations would deliver. (LocationĀ 3730)

A similar surge in optimism surrounded the US railway boom in the 1870s. The end of the Civil War saw a period of strong growth in the US and a huge increase in spending and investment in railways. Between 1868 and 1873, the volume of loans by banks, which helped fund the expansion, increased seven times faster than deposits. (LocationĀ 3734)

The US boom of the 1920s was also underpinned by technological and societal changes. This period bought with it huge interest in and growth of new consumer products. (LocationĀ 3738)

But when the 1920s crash came, radio stocks plummeted. The majority of radio manufacturers failed. The value of RCA stock, like that of many companies, collapsed by 98% between 1929 and 1932. It did not return to its former high for 30 years. (LocationĀ 3741)

In the 1920s era of optimism, confidence in the economy was not only driven by the new technologies but also by the belief that the ā€˜American systemā€™ of labour relations could boost productivity and demand. (LocationĀ 3748)

Many of the features of the 1920s boom in the US were to be found again during 1990s Japan. This bubble was driven by too much easy money, coupled with the belief that productivity had improved.17 A virtuous cycle emerged, fuelled by easily available finance, low interest rates and strong growth. (LocationĀ 3754)

Excitement about the ability of innovations and technologies to generate broader gains occurred several times in the second half of the 20th century and was evident in the 1980s in the biotech sector and in the new PC revolution. (LocationĀ 3760)

Japan's bubble in the 1980s also reflected a belief in a new era ā€“ this time in the potential for Japan to become the biggest economy in the world. (LocationĀ 3766)

The technology bubble that developed in many countries in the late 1990s became more broad-based and fuelled companies across the technology, telecom and media industries (commonly referred to as TMT). (LocationĀ 3781)

Light touch regulation, or deregulation, is often an ingredient in the buildup of financial bubbles. (LocationĀ 3790)

It also made it much easier for large numbers of an increasingly enthralled public to invest in the new companies. (LocationĀ 3794)

During the railway boom in Great Britain in the mid-19th century, the process of applying for permits to build new railways was relaxed. (LocationĀ 3796)

Deregulation and greater confidence in institutions also played a role in the boom of the 1920s. (LocationĀ 3800)

The 1980s Japan bubble was also facilitated in part by a process of deregulation. In 1981, for example, the Ministry of Finance gave Japanese companies permission to issue warrants in the Eurobond market in London. (LocationĀ 3803)

In 1984, Japan's Ministry of Finance also allowed companies to create special, so-called Tokkin accounts for their shareholdings, which allowed companies to trade securities without having to pay any capital gains tax on their profits. (LocationĀ 3810)

Although derivative markets boomed in the 2000s, other forms of innovation were at play in the housing market and were central to the sub-prime boom and subsequent banking and stock market collapse of 2007/2008. (LocationĀ 3821)

As Carlota Perez (2009) put it, ā€˜the term ā€œmasters of the universeā€, often quoted to refer to the financial geniuses that were supposed to have engineered the unending prosperity of the mid-2000s, expresses the way in which they were seen as powerful innovators, spreading risk and somehow magically evaporating it in the vast complexity of the financial galaxyā€™. (LocationĀ 3824)

Similar to many other bubbles that followed, the rapid growth of new entrants in the 1873 US railway bubble was also facilitated by easy money and new exchange banks that would offer loans against the collateral of (LocationĀ 3837)

railway shares. (LocationĀ 3839)

As policy tightened, railroad entrepreneurs needed to secure more capital to continue the rapid growth of the railroads. (LocationĀ 3843)

Having sourced a huge loan from the government, fears emerged that his company's credit and eventually his company was not good, and he declared bankruptcy in 1873 resulting in the start of the crash. (LocationĀ 3845)

John Kenneth Galbraith (1955) argued that an explosion in margin borrowing was also significant as a cause of the 1929 crash. Later, it was argued to have been a significant contributor to the 1987 crash, and cheap credit was also central to the Japanese bubble. (LocationĀ 3848)

Cheap and available credit was also a hallmark of the dotcom bubble in the late 1990s. Record amounts of capital flowed into the Nasdaq in 1997. (LocationĀ 3856)

Many bubbles in history were fuelled by a belief that ā€˜this time is differentā€™, and this has encouraged investors to look at, and justify, new ways of valuing companies. (LocationĀ 3861)

During the 1920s, for example, several academics argued that stocks were no riskier than bonds but offered greater potential returns. (LocationĀ 3862)

Others, such as Charles Dice in his book New Levels in the Stock Market,27 argued that stock prices in the late 1920s were too low. The market, in his view, had not yet priced in the triple revolutions in production, distribution and finance that were raising the value of US industry. (LocationĀ 3865)

Benjamin Graham in The Intelligent Investor (1949)28 argued that ā€˜old standards of valuation are no longer applicableā€™ as the Fed's attempt to avoid depression through very low interest rates had raised the growth potential of the economy and, therefore, the value of stocks. (LocationĀ 3869)

The Economist wrote (April 15, 1989): ā€˜What Japanese investors have become aware of is the dramatic way Japan's blue chip companies have changed the sources of their earnings through restructuring. This has made their profits too erratic to give any meaning to rigid measures such as a P/E ratio. Instead, investors have started to assess a company's future stream of earnings by looking at the total value of the firm's assets [ā€¦] the implication is that shares may be underpriced.ā€™ (LocationĀ 3879)

Post-bubble realisations of accounting problems have been another regular feature of bubbles throughout history. (LocationĀ 3890)

Three years after the UK railway bubble had burst (1848), Arthur Smith wrote a book entitled The Bubble of the Age; or, the Fallacy of Railway Investment, Railway Accounts, and Railway Dividends. (LocationĀ 3892)

What is interesting about this bubble is that, once it had burst, there was a broad revelation that accounting abuse had taken place. (LocationĀ 3894)

Graham and Dodd noted in 1934 (in Security Analysis) that ā€˜in 1928 and 1929 there occurred a wholesale and disastrous relaxation of the standards of safety previously observed by the exhibit houses of issue. (LocationĀ 3900)

Benjamin Graham and David Dodd (1934) wrote that ā€˜instead of judging the market by established standards of value, the new era based its standards of value upon the market priceā€™. (LocationĀ 3914)

Perhaps the most famous was that of Enron, a company that Fortune magazine had named America's most innovative company for 6 years in a row from 1996 to 2001.33 (LocationĀ 3917)

In sum, although all of the episodes discussed in this chapter were clearly different, the common features of the bubble or mania periods have been as follows: (LocationĀ 3923)

A belief in a ā€˜new eraā€™ or technology. (LocationĀ 3924)

Deregulation and financial innovation. Easy availability of credit and financial conditions. Justification of new valuation measures. The emergence of accounting scandals and irregularities. (LocationĀ 3925)

Not all cycles are alike, but the environment since the global financial crisis of 2007ā€“2009 has been particularly unusual, given that many of the traditional patterns and relationships between economic and financial markets have changed and, in some cases, appear to have broken down. (LocationĀ 4031)

One such study estimates that the financial crisis persistently lowered US output by roughly 7 percentage points, representing a lifetime income loss in present-discounted value terms of about $70,000 for every US citizen. (LocationĀ 4040)

In particular, what makes the post-financial-crisis period so unusual is that the economic cycle has been much longer than normal, and much weaker. (LocationĀ 4112)

Taking the US as an example, the economy, at the time of writing, is now in its longest economic expansion for 150 years. (LocationĀ 4113)

The persistence of slow growth post the financial crisis has been even more evident in other parts of the world, in particular in Europe, where the impact of the sovereign debt and banking crises has been even greater. (LocationĀ 4117)

Specifically, ā€˜a recession and recovery path associated with a financial crisis peak is likely to be much more prolonged and more painful than that found after a normal peakā€™. A similar observation has been made in other studies.8 (LocationĀ 4125)

What is striking about the post-financial-crisis cycle, particularly given the weak economic backdrop, has been the strength of the rebound in equity prices. (LocationĀ 4140)

the recovery in equity markets has been a function of loose financial conditions, zero interest rates and QE, but it is telling that the recovery in equity markets in this cycle has been much sharper than following similarly deep bear markets in the past. (LocationĀ 4152)

Part of the success of financial assets over the past 10 years has been that they have all been driven by a common factor ā€“ falling risk-free rates, which have contributed to rising valuations. Although equities have achieved higher returns than bonds, the impact of loose monetary policy has been felt across all asset classes. (LocationĀ 4171)

valuation has driven a higher proportion of returns in the post-financial-crisis period than on average in the past, particularly in Europe. (LocationĀ 4189)

Although interest rates and inflation expectations have fallen, there has also been a significant fall in long-term growth rates since the financial crisis. (LocationĀ 4230)

One of the other unusual developments that has emerged since the financial crisis is that, despite rising employment, wages and inflation have remained very low. (LocationĀ 4264)

The relentless rise in corporate profit margins since the financial crisis has certainly helped to offset what has been (LocationĀ 4274)

a weakening backdrop of sales growth. There are potentially many reasons why corporate margins have increased dramatically. The lack of pricing power in the labour market (reflecting the growing power of technology) and also the rapid rise in margins in the faster-growing technology (LocationĀ 4275)

German wage inflation has been low in recent years, despite low unemployment, partly because if workers push for higher wages there is a greater chance of these higher-paid jobs shifting to central Europe and elsewhere where the labour market is closely integrated into the German economy. (LocationĀ 4277)

Typical drivers of past recessions, such as industrial shocks, oil shocks and inflationary overheating, have become less of a threat since the financial crisis. (LocationĀ 4301)

The lower volatility of financial assets should make cycles more predictable, as long as this remains the case, but it is plausible that the anchoring of inflation and low rates will make cycles much longer in the future. (LocationĀ 4315)

Another important change that has influenced the evolution of the equity cycle since the financial crisis has been the impact of technology and its effect on returns. The dramatic growth of some technology companies (or companies that utilise new technologies to disrupt traditional industries, including retail, restaurants, taxis, hotels and banking) has meant that the distribution of profits has diminished even compared with past cycles. (LocationĀ 4331)

particular, looking at global aggregates, the value segment of stock markets (generally low valuation companies) has significantly underperformed so-called growth companies (those with higher expected future growth) (Exhibit 9.17). (LocationĀ 4350)

First, growth has been scarce and, therefore, generally highly valued. We have already seen that revenue growth has trended downwards since the financial crisis, but in general the proportion of companies with high growth in most equity markets (LocationĀ 4358)

Third, lower yields have boosted defensives relative to cyclicals. This is a similar theme to growth versus value. Many of the cyclical sectors are those with a low P/E, whereas most of the defensives are seen to offer better growth or, more important, predictable growth (LocationĀ 4383)

Fifth, the shift towards favouring growth relative to value has also had a meaningful impact on the relative performance of different regions of the world. In particular, there has been a persistent trend of outperformance of the US equity market relative to other equity markets since the financial crisis, and this is particularly clear when we compare the performance of the US equity market with that of Europe. (LocationĀ 4389)

To be sure, there are important differences between the financial cycles in Japan since 1990 and the rest of the world post 2008. For one thing, the scale of the bubble in land and property prices in Japan's case was much greater. (LocationĀ 4432)

Defensive companies that have relatively low sensitivity to the vagaries of economic growth rates have also outperformed in Japan since the 1990s, and the strongest of these were the ā€˜growth defensivesā€™ ā€“ consumer staples and health care (exhibit 9.25); (LocationĀ 4454)

So what does a global environment of negative risk-free rates do for the cycle and for asset valuations and returns? Both theory and history support the argument that lower interest rates should increase the value of equities, all else being equal. (LocationĀ 4614)

Since the financial crisis, as bond yields have fallen relentlessly, the gap between the two has increased. In other words, the equity market P/E valuation is lower (its earnings yield is higher) than might have been expected given the falls in risk-free interest rates, (LocationĀ 4626)

P/E ratios in both of these equity markets are at the same level, and both are below that of the US equity market, which has higher bond yields. (LocationĀ 4717)

The slowing rate of long-term growth in corporate earnings, a development that has been present in Japan for 20 years, is also emerging in Europe as its bond yields, like those of Japan, fall below zero (exhibit 10.13). (LocationĀ 4736)

In both cases, these lower bond yields may be partly a function of other structural factors related to demographics. (LocationĀ 4753)

The life cycle investment hypothesis (Modigliani and Brumberg 1980) argues that people borrow more when they are young and save more when they are old; with a growing proportion of old or middle-aged people, there should be more demand for income-generating safe assets (such as government bonds), which would push prices up and yields down. (LocationĀ 4756)

One other interesting aspect of zero or negative interest rates is how it has affected the preference for risk assets among long-term investing institutions, such as pension funds and insurance companies. (LocationĀ 4769)

For a typical defined-benefit pension plan, a 100-basis-point drop in long-term bond yields could mean, all else being equal, an immediate increase of liabilities in the order of 20%.7 (LocationĀ 4772)

Companies that have large future pension liabilities have been heavily affected by the crisis and the subsequent falls in interest rates (which have increased the net present value of the deficits). (LocationĀ 4784)

This economic cycle has been weaker but longer than usual. Meanwhile, the equity market cycle has been stronger. (LocationĀ 4871)

The ability of technology companies to leverage their products while employing less capital in their businesses has also had a dramatic impact on the relative performance of sectors and companies in this cycle. (LocationĀ 4890)

One of the earliest and most important waves of technology that revolutionised the way in which the world's economies operated, and how people worked and communicated, was triggered by the invention of the printing press in 1454. (LocationĀ 4905)

Cheap money and a new (revolutionary) technology attracted a surge in investment, which, in turn, had knock-on effects for the growth in the number of factories, urbanisation and the emergence of new retail markets, all of which was not an obvious consequence at the time. (LocationĀ 4933)

Another example of extraordinary waves of innovation came with the rapid growth in electricity generation in the early 20th century. (LocationĀ 4952)

As with other waves of technology that preceded it, prices collapsed. The real price of electricity fell by about 80% between 1900 and 1920,4 enabling the growth of many other related products (the radio, for example). (LocationĀ 4954)

investors often look at the disruptive impact of technology, assuming that it will displace existing industry, but often find that it is additive rather than disruptive. (LocationĀ 4959)

As it turned out, railways actually created an increased demand for horses because there remained a requirement to transport to the final destination or to the starting destination of a railway station. (LocationĀ 4961)

In addition to new opportunities, often some forms of adaption by traditional industries are displaced by new technology. (LocationĀ 4969)

One aspect of the current technology boom that has dominated the equity cycle in the past 10 years or so is that economic growth and productivity growth have generally been low. (LocationĀ 4980)

But there is strong evidence from history that previous waves of technology have also resulted in slower growth in productivity and economic activity than is generally believed. (LocationĀ 4983)

Several academic studies have shown that the improvements in productivity in Britain in the late 19th century were small. (LocationĀ 4986)

Productivity growth was slow during the last decades of the 18th century, and it did not improve until 1830. (LocationĀ 4988)

These innovations did not yield substantial (LocationĀ 4990)

Equally, the large fixed costs of investment could be recouped only when enough new users had switched to the new power source. (LocationĀ 4999)

In 1987, Nobel Laureate Robert Solow argued that ā€˜you can see the computer age everywhere except in the productivity statisticsā€™.12 These concerns faded when many economies saw a dramatic improvement in productivity in the 1990s. (LocationĀ 5005)

This is an important point because it suggests that the weak economic growth encountered post the financial crisis might, at least in small part, be explained by the mismeasurement of the impact of technology on growth and productivity. (LocationĀ 5018)

Companies that invent/innovate (the printing press, radio, TV) (LocationĀ 5026)

Although innovators do tend to be winners, not all innovators or first movers in technology succeed. History is littered with examples of entrants into a new industry but very few succeed. (LocationĀ 5027)

Companies that create the infrastructure to support new inventions (railways/oil/power generation/internet search engines) (LocationĀ 5033)

As described, the network companies can end up being highly dominant, but it is difficult to know with certainty at the outset which is likely to survive. (LocationĀ 5035)

Companies that utilise new innovations to disrupt/displace incumbents in existing industries (think of technology platforms/marketplaces) (LocationĀ 5038)

As The Economist wrote, ā€˜Size begets size: the more sellers Amazon, say, can attract, the more buyers will shop there, which attracts more sellers, and so (LocationĀ 5040)

Taking the history of the sector composition of the S&P 500 as a benchmark, sector dominance is clearly not a new phenomenon. Over time, different waves of technology resulted in different phases of sector dominance; as stock markets have become more diversified, the biggest sector has tended to account for a smaller share of the aggregate market. (LocationĀ 5049)