Bye Bye Miss American Pie

"Bye Bye Miss American Pie" is a classic song by Don Mclean that regaled the bygone era of 1950s-style rock and roll [here]. By 1971, when the song came out, music had changed a lot - which reflected the changing temperament of the country after several years of protests in the 1960s and an escalating conflict in Vietnam. In recalling how he can, "still remember how that music used to make me smile," Mclean conjures up nostalgia for a time when music was mainly about dancing and being happy. The song marked the end of an era in music but also more broadly of American culture.


So too may we be coming to the end of another era - that of the nearly dogmatic inclusion of stocks in investment portfolios. While consistently double digit returns in the 1980s and 1990s endeared many investors to the virtues of stocks, a fresh look reveals that nearly every argument for stocks is weaker now than it was twenty or thirty years ago. In short, several factors merit not only a fundamental rethink of the role of stocks in one's portfolio, but also of the entire process of managing wealth.

One of the biggest reasons for owning stocks is to participate in economic growth. As Gary Shilling explained in his March 2016 newsletter, "In the long run, the growth rates for nominal GDP and profits are similar. This means that over time, stock prices ride up with nominal GDP."

As Shilling also explains, however, economic trends have not been favorable - and this hurts the case for stocks. Specifically, the recovery since 2009 has been the weakest in at least the last 60 years at 2.2% per year. Indeed, the last three economic recoveries (at 2.8% in 2002 and 3.6% in 1991) are the three weakest in that time period and each one has been weaker than its predecessor.

Further, underlying trends in the key components of economic growth, population growth and productivity, are both weak. Recent productivity results have actually been negative. As the Wall Street Journalreports: "Nonfarm business productivity—the goods and services produced each hour by American workers—decreased at a 0.5% seasonally adjusted annual rate in the second quarter." The article goes on to explain that, "The longest slide in worker productivity since the late 1970s is haunting the U.S. economy’s long-term prospects." As the economy's prospects are "haunted", so too are those for stocks.

If stocks were cheap and poor economic prospects were fully discounted, that would be one thing, but they aren't. Valuation is another factor working against stocks as we have mentioned before. The old adage "buy low and sell high" doesn't work if you keep buying stocks at high and higher valuations.

While valuations do tend to move in cycles, they move in very long cycles and many investors do not fully appreciate the ramifications. Financial market history reveals pretty clearly that valuation cycles tend to last two or three decades. For individuals, that is a huge portion of one's adult life which can fundamentally reshape retirement plans if caught at the wrong time. Even for most organizations, that is a long enough period to outlast most board members, organizational leadership and perhaps even investment policy. As a result, it pays to consider the valuation risks seriously for most investors.

In addition to capturing economic growth, another core rationale for owning stocks is to receive the only "free lunch" in investing: diversification. Because stocks tend to behave differently than bonds and other assets, much of the risk of owning stocks can be mitigated by diversifying across different asset classes. This is a foundational concept for the vast majority of portfolio construction and wealth management.

In real life, however, correlations across asset classes are not static over time. Indeed, as Zerohedge reports in a piece, the markets are currently experiencing an "elevated level of cross-asset correlations." More specifically, "As Bloomberg notes, the Credit Suisse data, which tracks price relationships in equities, credit, currencies and commodities, shows that different markets are influencing each other in 2016 at a higher rate that any time since the measure was invented in 2008. The indicator assesses how much movements in one market are statistically explained by movements in another." So while almost everyone pays tribute to the importance of diversification, very few call it out when it is not working well.

Finally, another development that has weakened the case for stocks is that the public markets for stocks have become less dynamic and, arguably, less capable of the same levels of value creation as in the past.

One of the ways in which markets have become less dynamic is through a quiet but powerful consolidation. For instance, the Economist reports that "The number of listed companies in America nearly halved between 1997 and 2013, from 6,797 to 3,485, according to Gustavo Grullon of Rice University and two colleagues, reflecting the trend towards consolidation and growing size." That's right; the number of stocks is almost one-half of what it was twenty years ago!

As the number of public stocks has been shrinking, the existing ones have gotten even bigger. According to the Economist, "The share of nominal GDP generated by the Fortune 100 biggest American companies rose from about 33% of GDP in 1994 to 46% in 2013." The Financial Times also reported that, "Companies are growing older, competition is less fierce and market power is consolidating in the hands of a few large companies in many industries."