Coping With The Next Crash
Whichever way we look at it, we are in strange and unchartered territory regarding wealth creation and preservation.
As the world emerges from the global COVID pandemic, governments continue to spend massive amounts of money to try to get their economies firing on all cylinders.
Mortgage debt is as cheap as it's ever been, with the Nationwide Building Society offering the cheapest five-year fixed-rate mortgage on record.
Price inflation is picking up strength, with the latest UK figures showing an annual rate of 2.4%, well above the Bank of England's target rate of 2%.
On top of that, central banks continue to create enormous amounts of digital money through their quantitative easing programs.
Company shares, fixed income bonds and residential property have all seen values hit all-time highs.
Rising asset values cause what is known as the 'Positive income effect'. This means that investors start spending some of their unearned gains, which, in turn, spur economic activity, reinforcing investors' optimistic sentiment.
Housing
Housing has seen the average price to median earnings ratio rise to around 7 in the UK. But it is over 25 in some parts of London and the southeast, as this recent article explains.
Research firm Oxford Economics thinks that residential property in most developed countries is at least 10% overvalued after a substantial period of growth.
Bonds
Many investment experts say we are witnessing the biggest overpricing of bonds in history, particularly risky bonds. The yield on 10-year gilts has fallen consistently for the past 15 years, as the chart below shows.
Source: www.worldgovernmentbonds.com
When interest rates rise, the open market price of bonds falls. As a general rule, every 1% rise in interest rates results in a 1% fall for every year until the bond matures.
So, if general interest rates rose 1%, a bond fund with an average term to maturity (known as duration) of underlying bonds holdings of 10 years, would result in a 10% fall in the capital value of the bond fund (10 x 1%). Bond funds which hold a portfolio of bonds with a longer average duration and higher rises in general interest rates would result in larger falls.
Shares
While the very long-term trend is a relentless rise in post-inflation values of company shares (equities), this is punctuated by severe falls.
Timeline, the financial planning software provider, has an interesting chart showing the rise of the stockmarket, including the crashes, over the past 100 years. Overlaying the major world events that happened throughout that period, shows just how uncertain investing can be.
Source: www.timelineapp.co (c) 2021 All rights reserved. Reproduced by kind permission.
The UK stockmarket experiences surges (known as a bull market) then crashes (known as a bear market).
Falls can happen at any time, they can be severe and quick. For example, in the 33 days between 19th February and 23rd March, when the Coronavirus pandemic became real, the FTSE All-Share Index fell by 33% and the MSCI World Index declined by 34%. But the fall, when viewed between February 2020 and April 2020 was “only” 25%.
Spare a thought for investors in the early 1970s. In the 1972-74 period the stockmarket fell over 67%!
But big falls are usually followed by even bigger rises.
The chart below shows all the main bull and bear markets over the past 100 years.
Source: www.timelineapp.co (c) 2021 All rights reserved. Reproduced by kind permission.
The chart below shows these bull and bear markets visually.
Source: www.timelineapp.co (c) 2021 All rights reserved. Reproduced by kind permission
Jeremy Grantham is famous for his ability to pick investment bubbles. The co-founder and Long-Term Investment Strategist at GMO Investment and Asset Management correctly called the Japanese equity bubble in the late '80s, and the tech bubble in the late '90s and early 2000s. And in a September 2007 article for Fortune Magazine, he warned investors,
"As wonderfully favorable factors cool off, asset prices will be under broad pressure, and risky assets will be under extreme pressure. If the credit crisis gets out of control, this will happen quickly and painfully."
On 9th October 2007, the Dow Jones Industrial Average of leading US shares hit a high, closing at 14,164.53. The global financial crisis then started to unfold. By 5th March 2009 the Dow had dropped more than 50% to 6,594.44.
In an interview for CNBC on 12th November last year, Grantham made this point:
"The one reality that you can never change is that a higher-priced asset will produce a lower return than a lower-priced asset. You can't have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both – and the price we pay for having this market go higher and higher is a lower 10-year return from the peak."
In a recent interview for Live Wire Markets Grantham made the following prediction:
"The bigger bubbles are more painful, that's it. The definition of a bubble is pretty easy. We say two sigma. If you want to dress it up more from just numbers, you then insist on it having behavioral features like crazy behavior, and that's more a sign of the end. This one has done its duty on every front. It's entertaining, spectacular. I have no doubt that I cannot persuade anybody not to speculate. It is far too gripping, thrilling, and everyone's in it together. It's irresistible. All I can do is point out, like a historian really, this is what it feels like. It feels wonderful. They go up like this, they deviate at the end, then they crash, and they go all the way back to what is a fair price. And that's what will happen this time."
When we see our wealth fall, we tend to spend less. and this is known as the 'Negative Income Effect'. This can contribute to a downward economic spiral, reinforcing negative investor sentiment, which further depresses asset values.
What Does This Mean?
If you are still accumulating wealth and unlikely to touch it for at least 15 years or so and will continue to make regular investments into a diversified investment portfolio (whether through a pension plan or other type of investment account), the next stock market crash is unlikely to affect you much.
The long term trend is for capitalism to reward the patient long-term investor. When markets fall sharply in value, it is a bit like a sale, in that you buy more investments for your money.
And if you are buying a home to live in, you can put down at least a 15% deposit and are happy to stay put for at least 5 years, you should be able to ride out any future property crash.
The real problem is if you expect to use your investment capital (including drawing a regular income from it) or downsize your home to realise capital within the next 5-10 years. A big fall in stockmarkets or the housing market could seriously harm your financial wellbeing.
Jeremy Grantham made the point earlier that ‘when we invest at high prices, the future investment return we can expect should be lower than when we invest at lower prices’. This has implications for financial planning and the lifestyle you can expect to fund from your accumulated wealth. It might mean you need to change your financial planning assumptions.
“Jeremy Grantham makes the point that ‘when we invest at high prices, the future investment return we can expect should be lower than when we invest at lower prices’.” Tweet This
I have no more idea than the next person when the next stock market or property crash will happen or how severe it will be, but it's a case of when, not if. So it makes sense to do financial planning ‘lifeboat drills’ now, so you know what you’ll do when the inevitable happens.
A fixed fee chartered or certified financial planner can help you understand the impact of a significant fall in asset values or lower investment returns on your future plans.
That way you won’t end up panicking and getting wiped out with everyone else when the inevitable crash happens.