A Permanent Financial Crisis?
The current financial crisis began in the summer of 2007 with the credit crunch and continues with the European sovereign debt and banking crisis. More than four years after the crisis began, U.S. equity markets are nowhere near their 2007 high of 14,141 on the Dow. Bill Gross of PIMCO has declared the New Normal, an environment characterized by lower-than-normal economic growth, higher-than-normal unemployment, and unattractive market returns.
Yet most long-term investors have taken the position that “this, too, shall pass.” That is to say, most investor portfolios are positioned near their long-term targets, targets that were developed using long-term risk and return assumptions that haven't played out for a decade. Indeed, over the past 30 years, bond returns have outpaced stock returns, an outcome that turns market theory on its head.
Investors are aware of all this, of course, but are now reduced to hoping that the markets will mean-revert, as they usually do, meaning that in the coming years returns should be much better than they have been in the past and that the traditional relationship between risk and return will reassert itself.
No doubt all that will happen, but the question is, when? In their seminal work, This Time Is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff make the point that recovery from the deepest financial crises takes, on average, 10 to 12 years.6 If I measure from 2007, it's possible that we still have more than five years to go before we will have fully recovered. And if the Western countries should slip into a Japanese-style “lost two decades,”7 well, all bets are off. Looking back from, say, 2030, our children could find to their sorrow that equity returns have been far below par for half a century.