Originally published: April, 2003 (Phillips, Hager & North Investment Funds Quarterly Report)

Context of the article: The stock market had been going down for three years. Three year returns for the Canadian and U.S. markets (Cdn $) were -11% per annum and -16% respectively. The article spells out what a market bottom should feel like and makes a case for attractive equity returns in the years ahead.

After three years of negative equity returns, it's becoming difficult to remember when stock market investing was ever rewarding. We're all getting weary and discouraged and, at times, downright mad. We're sick of listening to advisors (including yours truly) tell us to buy stocks on weakness, whether it was in September of 2001 or at various other market lows since then.

Despite this grinding bear market, however, PH&N has not given up on the notion that equities will provide attractive returns in the years to come. I'll address the fundamental aspects of that view in a moment, but first let's consider the behavioural side.

Investing requires that we negotiate constantly between emotion and reason. Between short term and long term. Between fear and greed. To deal with these conflicting forces at this difficult time in the market, it would be helpful to know what a stock market bottom should feel like. Each market cycle is different, of course, and the bottom will only look like an irresistible buying opportunity in hindsight, years later. When we are actually living it, however, I suspect it may have many of the following characteristics.

  • At the bottom, the most popular commentators will be the bearish rantors. They have the most credibility (after all, they have been right) and the press will have embraced their views.
  • In a similar vein, the most widely reported earnings releases will be those where companies fail to live up to analysts' estimates. Even if the market's overall earnings base is starting to grow again, these "negative surprises" will garner most of the headlines.
  • At the bottom, it will be accepted wisdom that the stock market is going to provide only modest returns in the years ahead, despite the fact that it is down significantly. Generally, people will be delighted to hear they can earn 6-7% on any kind of investment.
  • Everyone will have a view, and a statistic, to show how the market is overvalued.
  • The RRSP season will be a non-event. No matter how much advertising they do, mutual fund companies will not be able to convince investors to make their usual contributions. What inflow there is will be directed toward conservative or income-oriented funds.
  • For the most part, experienced investors will be "hanging in" with their equity holdings. By this I mean that they will no longer be selling - but they won't be putting new money into stocks either. They will be procrastinating when it comes to doing their regular rebalancing.
  • At the bottom, real estate will be popular, even if prices have risen dramatically. Phrases like "you can't lose in real estate" will be heard often.

These observations feed into comments made by one of my favourite analysts, Peter Bernstein, who says that market bottoms (and tops) are defined by a "switch from doubt to certainty". He goes further to say, "in calmer moments, investors recognize their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions: they act as though uncertainty has vanished and the outcome is beyond doubt".

In my opinion, we have moved into a period of "certainty", and a rather gloomy one at that. The forces that are winning the battle are short term, fear and emotion. Equity investors now have a strong conviction that the next three years will look a lot like the last three, and are positioning their portfolios accordingly.

What is PH&N's view? We are always in the camp of long term and reason. Right now, on the spectrum between greed and fear, we think investors should be more greedy than afraid. We believe that equity investing will be a rewarding pursuit in the years to come. Indeed, it could be very rewarding in the next few years (i.e., double-digit returns) given the extreme environment in which we now find ourselves. We can't know the timing or magnitude of the market rise, but I believe that we are somewhere near the bottom of the stock market cycle. Am I sure about those double-digit returns? No, but I'm reasonably confident (not certain!) that stocks will at least beat low-yielding bonds over the next 2-3 years.

The valuation gap between stocks and bonds has grown very wide. There are three ways that this gap can narrow. Stock prices could go up. Or bond prices could drop as a result of rising interest rates. Or earnings estimates could drop, which raises the valuation on stocks. Of the three possibilities, a rising stock market would be the best resolution, but in all likelihood it will be some combination of the three. Bonds have been in a twenty-year bull market and appear to be fully valued. Bond investors are assuming that future inflation will be considerably lower than it is currently. That may be a heroic assumption. As for earnings, expectations may have further to drop, but I think estimates are now quite subdued. Perhaps I could be accused of having too much faith in the resilience of modern business, but I do think that companies are adapting and getting back on the growth track.

I don't doubt that many of the market's gloomy predictions will prove to be true, whether it be the economic disruption caused by the Middle East war, a decline in consumer spending, or a high-profile bank failure. The consensus is often right. What investors have to decide is: How much money is there to be made from siding with these predictions? I don't think there is much more to be gained, since a gloomy consensus or "certainty" has already been factored into bond and stock prices. If, on the other hand, the consensus is wrong, there is plenty to be gained by the investor who is positioned for it.

The Peter Bernstein quotes are taken from a chapter he wrote for the book, Financial Times Mastering Investment: Your Single-Source Guide to Becoming a Master of Investment.

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