Breaking Investment Theory by Umar Saeed

The global financial saga continues. Once Greece is cooked, Italy will follow, then maybe Spain and Portugal. Europe’s problems, much like America’s, are partly financial. There is legitimate concern that the banking system itself is overextended. There’s additional worry that these countries have too much debt, which is why the bond markets are punishing them. During times like this, you’ll notice the stock market (or your mutual fund) is losing money. However, your financial advisor is trained to tell you one thing: stay the course. They will continue to say it no matter how bad it gets.

Europe and America have had a long history of racking up debt. So why do bond markets suddenly find this intolerable? The answer is that these distressed nations have limited economic growth prospects. It’s become evident that Western nations don’t really make anything anymore and we’ve milked financial innovation for all it was worth. Without the ability of national incomes to grow, it makes paying off the debt harder, which is why bond markets are demanding austerity (tax hikes or spending cuts to reduce debt). This is a lot like your bank allowing you unlimited credit as long as you continued to make more money each year, but as soon as your wages froze, they put a limit on that credit card.

With diminished growth prospects, the outlook on the stock market has become pessimistic. But to scrutinize the “stay the course” advice, we have to know where it comes from. Stay the course says that yeah, sure, stock markets go up and down, but in the long run stock markets always rise. I’ve performed analysis on what exactly “long run” means and how investment theory became so ubiquitous, but the question we must ask now is whether there’s a possibility that stock prices can stay flat or even decline in the long run. That would break the entire theory.

That stock prices rise in the long run is rarely questioned. That’s because all the empirical data that we have confirms it. Even adjusted for inflation, stocks beat all other investments over time. But humans are suckers for confirming evidence. There’s no shortage of stock charts showing upward sloping lines over the course of decades or generations.

But to truly test a theory, you have to search for disconfirming evidence, especially as stock prices are not governed by hard science rules. Saying stock markets always rise isn’t like saying when you drop something it will always fall. To find the disconfirming case, we look to modern day Japan.

Japanese businessmen

For roughly thirty years leading up to the nineties, the business book section was dedicated to discovering Asia’s miracle economy, Japan. The Japanese economy had grown fast and consistently, and through deregulation and an easy-money monetary policy during the eighties, Japanese asset prices rocketed upwards for the decade (real estate and stocks). In the end, Asia’s miracle ended up being over-leveraged investments and Japan’s economy came crashing down.

Startlingly similar to the Western world’s current situation, Japan has had a two decade head start on everyone else. Unfortunately, since its crash it has been mired with debt and low growth. People have spent the last couple of decades paying off debt, not spending money on goods and services. This is great for restoring healthy finances, but bad in terms of increasing national income growth.

What’s more interesting is that like Western countries, Japan also has an ageing population. The Bank of Japan has cited this demographic trend as one of the reasons why Japanese stock prices have remained stagnant. The Economist describes this phenomenon succinctly:

In simple terms, the young and middle-aged save for old age by buying assets, often with borrowed money; the old sell them to pay for retirement. As the working-age population rises—as it did, for instance, after the baby boom—asset prices rocket because of increased demand. As baby-boomers reach retirement, the reverse may happen.

Stock market values are based on the negotiations between buyers and sellers. Aggregating these moves, when the market is made up mostly of sellers, stock prices are driven downward. It’s not just individuals about to retire cashing in their stocks and mutual funds. Pension plans must do the same in order to begin making payments to former employees. Insurance companies must sell stocks to pay off death benefits and policy claims.

Consider that we poured a whole lot of financial innovation to accelerate stock market growth beyond what it normally would have been. Then recall that since 2008 the world has printed an unprecedented amount of money, which helped keep stock prices afloat. Everyone, nations and people, are in debt and working to pay them off. Now Western nations (including Canada) are entering the peak years of baby boomer retirements. It’s entirely possible to see a decade or more of continued stock market stagnation or decline.

You financial advisor will probably tell you I’m overthinking this. But consider that financial advisors get paid for attracting and keeping your money invested in their investment products, but nobody pays me for writing this. 

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Photo: protests in Greece

Umar Saeed is an accomplished professional in finance and accounting. On his website (www.umarsaeed.ca), where this post originally appeared, he writes essays to explain the elaborate connections between people and money, without making your head hurt. You can follow him on Twitter @UmarSaeedCA. Or you can read the rest of his posts at The Little Red Umbrella here.