Warren Buffett is not called the ‘Oracle of Omaha’ for nothing.
‘Be fearful when others are greedy, and be greedy when others are fearful’ is good investment advice looking back at the turmoil of September 2008.
The demise of Lehman Brothers five years ago marked the start of a truly fearful six months for investors. Only in March 2009 had risky asset prices fallen far enough for bargain-hunting buyers to begin picking up equities and lower-quality bonds.
On the anniversary this weekend of Lehman’s collapse, those investors who stayed the course in equities and junk bonds can afford a smile. The S&P 500 index has gained 50 per cent.
They have done well, though alternative bets made in 2008, such as buying a New York City taxicab medallion, have done even better.
Even buyers of certain commodities and US government and investment-grade bonds are sitting on handsome gains, in spite of a retreat across many asset classes from their post-Lehman peaks in 2010 and 2011.
The questions facing investors now, though, are very different. A sharp rise in bond yields and steep losses across emerging markets point to a world where the risk of rising interest rates – as the Federal Reserve starts to withdraw emergency stimulus – will be the greatest source of volatility.
Art Steinmetz, chief investment officer at OppenheimerFunds, says smaller investors face a rude awakening, as rising interest rates trigger declines in the value of their bond portfolios. “They have spent the past five years preparing for 2008,” he says. “The next crisis is clearly visible: rising interest rates.”
Certainly, any appraisal of the investment landscape today is influenced by the repercussions of Lehman’s collapse. Those include not just the financial and economic turmoil that followed, but the supporting role played by the Fed since 2008 that only now appears set to start shrinking.
The Fed and other central banks have undertaken extraordinary measures, such as the successive rounds of “quantitative easing” that suppressed interest rates to offset a savage deleveraging in the private sector and stimulate lending.
Yet, for all the vast sums of money spent by the Fed under QE, the end result has been a lacklustre economic recovery marked in the US by high unemployment.
Indeed, the major consequence of QE and near-zero interest rates has been the shift among a generation of retail investors into bonds. For much of the five years since Lehman, that move has proved lucrative. But the gains have masked risks.
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Mr Steinmetz says investors who have put as much money into bond funds as they did into growth stocks in the late 1990s “are overpaying for safety, and the only thing that is certain is that won’t meet their retirement goals”.
As the Fed prepares to take the first step towards normalising interest rates, equities may now be poised to eclipse debt. But when it comes to deciding between bonds and equities, much still depends on whether the Fed’s stimulus efforts will finally translate into a robust economic recovery.
“In a growing economy, the equity market will deliver a higher longer-term performance, but with greater volatility than bonds,” says Ashish Shah, head of global credit at AllianceBernstein. “Bonds are boring, but will provide income and equities will be where you get your excitement and higher longer-term gains.”
Mr Shah estimates that, over the next five years, holders of junk bonds should expect 6 to 7 per cent annual returns. “Over the next five years we won’t see the kind of returns produced since 2009, given today’s starting point for asset prices.”
Stronger economic data would go a long way towards easing concerns that companies’ earnings are too elevated and simply reflect cost-cutting and share buybacks, action that has masked tepid revenue growth for the S&P 500 index.
Jay Mueller, senior portfolio manager at Wells Capital Management, says corporate profits have bounced back sharply since Lehman, unlike the economy and employment. “But the question I ask is: how much longer can corporate profitability outperform the economy? We are not seeing impressive top-line growth.”
Commodities were seen as an alternative home for investors keen on assets that were uncorrelated with bonds and equities or which offered a good hedge against inflation.
However, they have proved to be neither since Lehman. In fact, they moved in close alignment with other asset classes until the past year, while fears that QE would lead to runaway inflation have so far failed to materialise.
The Dow Jones-UBS commodities index is down about a quarter on a total return basis since Lehman.
The price of Brent crude oil is nominally higher, at about $113 per barrel, but investors without oil tank leases would have lost 16 per cent as they rolled futures contracts from month to month. Gold is up 73 per cent, but down 30 per cent from its peak two years ago.
Douglas Hepworth, executive vice-president at Gresham Investment Management, says fears about inflation have not gone away. If anything, investors are now more worried about the effects of price rises than the need for diversification.
“What’s happened in the last five years has been a trade-off of consumer debt for government debt. So does inflation show up? Odds are pretty good.”
When so much uncertainty still surrounds the economy and Fed policy, trying to gauge the future performance of asset classes is extremely difficult. But the period since 2008 shows that being fearful is not necessarily the answer.
Mr Steinmetz says Oppenheimer is trying to persuade clients to “peek out from under the blanket” and shift large parts of their savings into equities, where the last four years may only be the start of the rally.