Expert View

Wednesday, 20th June 2012

What is the "Cult of Equity"?

In the late 1950's, all of the conditions were just right to spark a massive global shift into stocks from bonds. It happened in 1956 when Ross Goobey, the manager of UK's Imperial Tobacco pension fund, rocked the world when he said stocks provided better long-term inflation adjusted returns than bonds. Goobey's conclusion was based on the ground-breaking work of Nobel Prize-winning economist Harry Markowitz, the father of modern portfolio theory. Markowitz's theory was that a diversified portfolio of individually risky equities could be constructed to maximise return and minimise risk. The rise of the equity cult coincided with the rise of modern portfolio theory.

The combination of Markowitz's theory, the Ross Goobey moment, and the extraordinary real returns in the stock market ignited the beginning of the cult of equity (the 1950s was the best decade for real returns in the 20th century). Pension funds aggressively shifted their assets into stocks in the 1950s and this trend continued for fifty years.

Now, the Credit, Sovereign Debt and Euro Crises have once again transformed the economic and investment landscapes. A free-wheeling, debt-driven, de-regulated and high growth global economy has been replaced by a "new normal" world where growth is sub-normal, austerity is widespread, regulation is increasing and households, banks and governments are deleveraging their balance sheets – (reducing their debts).

In the investment world old certainties, such as "government debt is a risk free asset", have been eroded and replaced by new uncertainties – significant among those for investors has been the increase in counterparty risk – (Will the bank/government be able to give me back my money?)

Unsettled by these changes, investors have resorted to "short-termism", lurching from "risk on" strategies when the news background is good to "risk off" strategies when there is bad news.

Equities, normally a dominant asset in investment portfolios, are distrusted because of their failure over the past twenty years to generate the long term returns expected by investors, leading many to speculate that the "Cult of the Equity" could now be dead.