One of the biggest mistakes that I think investors make is that they assume the share market reflects the underlying fundamentals of the businesses. In addition to this, they also believe that over the long term, the markets will always go up. There are two fundamental issues with this thesis. The first is that many academic studies have proven that the short-term share market is not correlated to the underlying fundamentals of the businesses that it is comprised of. Secondly, what is an adequate period to reflect the long term?
Ben Graham has the famous quote “In the short term, the market is a voting machine in the long term, it is a weighing machine”.
In my view when it comes to investing anything less than 10 years should be considered the short term. I am going to use an example from history to demonstrate why I believe this to be the case.
In 1968 to 1982 interest rates went from around about 4% to a high of 20% over that period of time. It should be noted that over that time there was above-trend economic growth in real terms with companies being a lot more profitable. This resulted in investors in the equity market achieving a return over this period of approximately zero in nominal terms and actually lost 70% in real terms.
So, what drove this contraction?
Firstly, there were multiple contractions. When interest rates increase there is less incentive to buy equities to generate a return. For example, if you could buy a government bond earning 20% why would you need to buy equities? In 1968 the S&P was trading at 25 times earnings and by 1982 this had reduced to 4 times earnings.
Secondly, the risk premium increases as interest rates go up. This is a deleveraging as investors command more return from equity investing relative to bonds. At the moment we are in a period where we have seen risk compression and investors are not getting compensated for the extra risk they are taking within equities.
Article by: Rob Coyte, CEO, Shartru Wealth Management