The chart below shows the Dow Jones Industrials Average from 1947 to the present. This brief history of the Dow has been marked by two eras of rallying markets, followed by a long sideways market. We could be moving into another period of sideways markets for another decade or so.Poor macro-economic backdrop
There are valid fundamental reasons for these sideways markets. The last sideways pattern has been marked by rising inflationary expectations that begun with LBJ’s guns and butter policy in the Vietnam War. The macro-economic backdrop is not dissimilar to that of the late 1960s and 1970s. America is involved in a war with no end in sight, the fiscal deficit is spiraling out of control and the US Dollar is falling.
Excessive equity valuations
Some investors, like John Hussman, believe that the market is excessively priced. In a recent commentary he wrote that “the S&P 500 remains priced to deliver probable total returns of about 2-4% annually over the coming decade”. Using the methodology described here, Hussman indicates that the market’s cyclically adjusted P/E based on peak earnings is very high. Profit margins are elevated at this point of the cycle and there is the market is not pricing in any room for margin mean reversion (read analysis here).
Pension funds asset mixes likely to favor more bonds
Corporate treasurers are likely to move towards a asset-liability matching framework in defined benefits plans given the advent of changes in accounting policy such as FASB 158 and IAS 19. In Europe there are already suggestions to extend the Solvency II standard to corporate pension plans, which would further accelerate this trend (and has created scare stories like this).
We saw this effect in the UK a few years ago when companies moved towards an asset-liability matching framework. Investors drove the yield on the long-dated gilt to unbelievably low levels as they reached for duration in their portfolios. This asset shift came at the expense of equity weightings and other assets in the pension portfolio.
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