In the fifteenth century people used the phrase “safe haven” to speak of a place where fugitives went to get shelter or protection from their pursuers. Today we speak of safe havens as places where investors put their cash when they don’t want to take risks. From what or who are these investors running?
Since the beginning of the year the financial markets have seen an increase in volatility over the previous year. But this volatility may not be out of the ordinary. Investors may be running from something that isn’t really that dangerous.
Traditionally, in times of trouble and increased uncertainty about the economy investors moved capital from stocks to government bonds. This safe haven investment is proving unhelpful this year. While still a haven in that you are very unlikely to lose your investment principal, the returns on bonds are at all-time lows. Government bonds currently yield only 1 or 2 percent per year and have not risen in price even with the stock market declines we saw in January and February.
Another traditionally safe investment is precious metals. But here too, current returns are low. The price of gold is up for the year, but unchanged over the past twelve months.
In search of better returns some investors are turning back to real estate, despite large losses for this investing category during the financial crisis of 2008. As of late 2015, the S&P/Case-Shiller U.S. National Home Price Index was 5.3 percent higher year-over-year.[i] According to the Society of Industrial and Office Realtors, commercial real estate prices are currently rising at about 7 percent per year.[ii]
Before shifting much capital to precious metals, real estate, or any other so-called “alternative investments”, investors should consider if the recent stock market volatility is really that bad. Is the stock market response to slowing economic conditions and uncertainty surrounding the upcoming presidential election a reasonable adjustment or a sign of impending doom?
It turns out that a large drop in the value of stocks is consistent with only a small change in the forecasted growth rate of earnings. To explain this, financial economists use a process called the dividend-discount method of stock valuation. Applying this model to today’s market shows the current situation is consistent with just a slightly lower expected growth rate.
Stock investors in the United States and other developed countries have historically earned a 10 percent return over the long-run. It’s not unreasonable to expect this return in the future, but if dividends are going to grow more slowly because the economy is slowing, our economic model predicts a fairly strong change in current prices.
Suppose, for example, a company currently pays a $1 annual dividend and has historically grown this dividend by 5 percent per year. If investors are looking for a 10 percent long-run return the dividend-discount model then says this stock will sell for $20 ($1 divided by the expected return of 10 percent less the 5 percent growth rate). Investors in this stock are earning a 5 percent current yield ($1/20) but getting another 5 percent in growth, for a total return of 10 percent.
Suppose now that things change and investors think the company can only grow dividends by 4 percent per year. The stock price has to fall to $16.83 in order to earn them the same 10 percent long-run return (($1/$16.83) + 4 percent = 10 percent). So, a small reduction in the economic outlook for growth turns into a 16 percent drop in the stock price. Since the economic outlook can change for many reasons we should expect 10 or 20 percent swings in stock prices relatively often.
And this is only half the story. Compared to alternative investments, like gold and real estate, stocks aren’t all that risky.
Financial economists measure the investment risk in stocks, bonds, and other assets by their volatility; roughly the frequency and magnitude of price changes. The statistical measure of this concept is called standard deviation.
Since 2006 the standard deviation of the return on stocks in the Standard & Poor’s 500 index is 14 percent using monthly price data.[iii] Over the same period, returns on gold had a slightly higher standard deviation of 15 percent[iv], while the volatility in real estate was 22 percent as measured by the Wilshire US Real Estate Investment Trust index.[v] Metals and real estate are risky investments; that is, there is little protection in these so-called alternative investment classes.
So we can run to the investing haven of bonds and get a return that is currently below the rate of inflation, and never likely to be above it, or we can turn to the haven of metals and real estate and not be any safer.
Yes, the economic and political outlook is uncertain. But the greatest safety from whatever is pursuing your investment portfolio is simply the long-run value of stocks.
Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.