The 1990s saw stocks achieve "must-have" status with a vengeance. As a result, realistic long-term growth projections now suggest only a thin 1% equity risk premium over long-term inflation-indexed bonds. A low equity risk premium, in fact, may be warranted. Simply put, an integrated, transparent, convergent world where individual securities are priced as part of a highly diversified, global equity portfolio justifies a low equity risk premium.
Does this mean we can forget about risk now? Of course not. People who made the choice to invest in 1929 or 1969, both the start of plunging markets, lived to regret it. Part of responsible risk management is forcing yourself to think the unthinkable, going through the process of asking what might happen to the pension fund or endowment fund or foundation fund if a 2001-2010 version of the 1930s or 1970s lies ahead.
Three key preconditions for such an event are already in place: all seems well with the world; we have experienced an extended period of rising stock prices; and very few people are predicting that a bad decade lies ahead. Here are two scary scenarios for 2001-2010:
A deflation decade. This scenario starts with a stock market crash. Keep in mind that in behavioral finance, no material negative information that changes market expectations needs to appear to create a sudden, massive imbalance between buyers and sellers. As in the fall of 1929, it just happens. After the 2001 crash, other things start to go wrong. The intricate web of derivatives contracts begins to unravel. Highly leveraged consumers stop buying. The initial public offering market dries up, bankrupting many high-tech companies that have negative cash flow. Even positive cash-flow corporations are squeezed, caught with excess capacity. Central bankers finally regain control after massively intervening in the global securities markets. Stock markets stabilize in 2005 at 50% below their peaks in inflation-adjusted terms.
An inflation decade. The "hot" economy continues, despite central bankers' best attempts to create a soft landing. Commodity prices begin to spiral. The combination of high stock prices and the aging of the baby boom generation accelerates the trend toward early retirement. Serious labor shortages appear, creating a price-wage spiral. Interest rates rise materially. Stock market investors finally lose their nerve. A stock market crash ensues. Only when inflation and interest rates begin to stabilize in 2005 do stock prices find a floor 50% below their peaks in inflation-adjusted terms..
Implausible scenarios? Maybe. But remember the hapless folks who saw no risk in 1929 and 1969. They were wrong, and they suffered the consequences for an entire decade. It is not my purpose here to have you dump all your stocks and send you dashing for the nearest risk-free asset. Rather, it is to persuade you that episodes of sufficient duration have surprised investors in the past, so they can surprise you tomorrow. Responsible fiduciaries should insist on stress-testing the ability of the pension plan and its stakeholders to withstand such financial shocks.
Keith P. Ambachtsheer is president of K.P.A. Advisory Services Ltd., Toronto. His commentary is excerpted from an analysis in The Ambachtsheer Letter.
