Citi Says: The Bear Market Isn’t Over

It’s not widely known that the market spent most of its history as an asset-price bubble. It is certainly true that the great run-up of the last decade looks the part. And that doesn’t mean that everything we’ve experienced isn’t part of another great run-up: stocks are still no longer cheap, and pretty soon they will be expensive.

More fundamentally, though, it is absolutely clear that equities don’t behave like stocks in the long run. They’re up 150 percent in the last decade, but over the last 60 years, stocks have averaged annual gains of just a few percentage points. And even in the last decade, stocks haven’t nearly been as efficient at generating returns as others are willing to admit.

That last part is pretty relevant right now, because stocks, as a major asset class, have gotten much more efficient in recent years. A conventional view holds that the robots are taking over, and that high correlations between stocks make it impossible for one company to have a big enough impact on the broader market to beat the overall averages. In fact, what’s happening is more complicated: Stocks don’t actually trade in a uniform fashion, and they’re going to be inefficient for longer than anyone imagined.

Let’s look at a few numbers, starting with one that shows how far we have come since 2008: the difference between total returns for the S&P 500 and the returns for the Russell 2000 is down by 70 percent. Even though the Russell 2000 is a much smaller market, it has more companies, so it has more power to make giant moves. Consider the typical stock in the Russell 2000, General Motors, which was down about 65 percent from its peak in early 2007 to its trough in the fall of 2008, but that was a sample, and a fine one at that. Over the last 10 years, General Motors has returned nearly 5 percent annually.

What kind of bloat is happening in the Russell 2000? Well, it includes a lot of companies that are just much smaller than the S&P 500. For all of the index’s faults, it still has a margin of safety that other indexes don’t: if you want to participate in equity returns, you have to own an index.

One reason for the way that the Russell 2000 has fared lately is that its companies have become more volatile. It used to be the case that those extra few companies that figured out how to use accounting practices that led to losses were shunned by investors. But now, as the business of accounting has gotten more complicated, those companies can still make lots of money. In other words, everyone’s getting rich, including the traders who snapped up those stocks back in 2011. But what if those trades were not cheap, so we might not have used all that volume?

To review: It turns out that if you’re buying and selling stocks on any given day, you might not even have to be an investor at all. But there are still real-world economies at work, and they’re going to cause more volatility than stocks in the Russell 2000.

That reality has been in evidence in the last year or so. The S&P 500 has lost an average of 5 percent over the last six months, but the Russell 2000 hasn’t fared much better. That’s likely because the Russell 2000 has fewer stocks to sort out than the S&P 500, and therefore has more big winners to offset the inevitable losers. There aren’t as many indications that markets are actually becoming more efficient right now.

Of course, maybe this is simply the result of a huge stock-market correction. Investors tend to buy and sell just before and after corrections, so there could be some “buy-the-dip” selling going on. Even if that’s right, though, stocks aren’t going to look like the asset-price superstars they’ve been for the past decade and a half. Still, they have one potential ace in the hole, and that’s the high concentration of high-tech companies in the Russell 2000. As tech stocks bounce back from their recent losses, many high-flying companies will benefit from reduced volatility, which would make stocks a bit less efficient than they look right now.

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