The recent events of the financial market have discouraged
many investors from putting their money in equities. Investment dollars are
leaving the equity market in droves towards less risky government bonds. Despite
the many perils noted by market watchers and investment advisors, this analysis
presents a strong case for investing in equities for the long-term. The
Canadian equity market as represented by the S&P TSX has performed
impressively over the last almost three decades. As illustrated in Exhibit 1, while
the herd mentality of investors has resulted in a “crash and burn” outcome for
the TSX, the market returns have nonetheless been staggering over the long-term
with an accumulated return of 1106% over the 36 year period from 1976-2012
(YTD). This translates to a CAGR of 7.16% implying that if an individual
invested $100,000 in an index fund in 1976 that perfectly tracks the TSX, s/he
would have funds in excess of $1.2 million by 2012.
Exhibit 1
So how should one
navigate investments in the future?
The crash and burn scenario has been a norm in the Canadian
financial market. However, the severity of drawdown in the market has
experienced an uptick in the recent years. As shown in Exhibit 2, the long-term
gain in the market has been tapered by periodic corrections. The typical cycle in the Canadian stock
market has been a 4:1 cycle where the market is in the positive gaining
momentum for a period of four years and then corrects in the fifth year
dropping a significant percentage point.
Exhibit 2
The severity of negative events has increased significantly
post 2001. Exhibit 3 shows that whereas the quantum associated with negative
events preceding the dot-com boom experienced on average an 8% drawdown, in the
post 2001 world the average drawdown has gone up three folds to 25%.
Exhibit 3
It is expected that due to factors such as increased
globalization, financial product complexity, increased participation in the
financial markets etc, the new world order of sustained levels of high
volatility will continue. For example, increased globalization has meant that
now a number of global events affect the Canadian market exogenously. Thus, it
is expected that the crash and burn scenario will continue to take place on
average every four years. The markets will continue to show resilience, dusting
off its shoulder and carrying on for 4 years before getting hammered again.
For investors with a long-term investment horizon, the
equity market in Canada will provide an attractive return that will be well in
excess of risk free investment. As illustrated in Exhibit 4, a $100,000
investment in the equities market today will easily exceed the risk free return
in the long-run. There are four scenarios presented in Exhibit 4: risk free,
optimist, realistic and pessimistic. If an investor puts aside $100,000 in risk
free investments, he can expect to get almost $380,000 in 35 years. Even in the
most pessimistic of outcomes for the Canadian equity market, where the market
experiences 15% drop in value in the first 5 years increasing by 6 percentage
point every 5 year, such that by year 32, the market drops by 45%, the equity
market will still beat the risk free investment by providing almost twice the
returns. It should be noted that in the optimistic scenario the market
continues to experience its natural cycle, albeit less severe, dropping by 15%
in the fifth year and increasing by 2 percentage points henceforth every fifth
year. Under the optimistic scenario, an investment of $100,000 of principal in
year 1 will yield almost $1.7 million by year 35 which is 4.4 times higher than
risk free investment.
Exhibit 4
The next exhibit is a nail in the coffin for a decision
between a risk free investment and investment in market portfolio. This
scenario contemplates an equities market that performs twice as worst as the
most pessimistic scenario in Exhibit 4.
The risk free investment continues to earn a 4% return over the 35 year period
but the equities market, with its jagged edge route than previously considered still
ekes out a premium of 29% over the risk free return. It is important to gain a
better appreciation of what is in store for the equities market in Exhibit 5. Under this scenario, the
equities market will gain 16% during the four years up-swing cycles in the
market, dropping by 15% in the fifth year, 45% in year 10, 27% in year 15, 33%
in year 21, 39% in year 25 and finally 45% in year 30.
Exhibit 5
Exhibit 6 Main Assumptions
Assumption
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Detail
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Risk free rate
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Risk free rate of 4% is assumed over the 35 year period.
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Stock market cycle
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It is assumed that the equity markets follow a cycle where for 4 years
the annual returns are 16% annually and then the market goes down by a
certain percentage point depending on the scenario
|
Optimistic scenario
|
Market goes up by 16% annually in the first four years,
then drops by 15% in year 5, then goes up by 16% for subsequent 4 years and
drops by 17% in year 10. This 16% up and 2% incremental drawdown every five
year continues on until year 35.
|
Realistic scenario
|
Market goes up by 16% annually in the first four years, then drops by
15% in year 5, then goes up by 16% for subsequent 4 years and drops by 19% in
year 10. This 16% up and 4% incremental drawdown every five year continues on
until year 35.
|
Pessimistic scenario
|
Market goes up by 16% annually in the first four years,
then drops by 15% in year 5, then goes up by 16% for subsequent 4 years and
drops by 21% in year 10. This 16% up and 6% incremental drawdown every five
year continues on until year 35.
|
Worst x 2 scenario
|
Market goes up by 16% annually in the first four years, then drops by
15% in year 5, then goes up by 16% for subsequent 4 years and drops by 45% in
year 10. The market then recovers at 16% annually for the next 4 years and
then drops by 27% in year 15, dropping by 6% in every next 5 year cycle.
Finally the market drops by 45% again in year 30.
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Stock market investment decision
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It is assumed that investors either have a highly
diversified portfolio of investments that has a Beta of close to 1 or that
investors are invested in ETFs that closely tracks the performance of the
S&P TSX. This assumption is reasonable considering that most industry
reports have shown that investment managers at hedge funds and mutual funds
have largely been unable to beat the market performance. This combined with
the fact that investment products such as ETFs offer a low cost solution to
investing in the market means that it is highly likely that most equity
investors will experience the returns and cycles profiles in this analysis.
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