By Trevor Greetham

Following one of the worst decades for global stocks, the next 10 years are set to be positive – which could require a shift in asset allocation for many investors. Mean reversion, the phenomenon whereby a variable quantity tends to return towards its average value over time, applied after previous periods of comparable weakness as the markets returned towards the mean.

Previous comparable periods to the past decade include those of the two World Wars, the Great Depression and the inflationary 1970s.

Returns in the 10 years after a “lost decade”, defined as any 10-year period in which US equity returns were below the rate of inflation, averaged out at a healthy +11 per cent per annum in real terms*.

There is some way still to go for stocks to return to the mean. Stock valuations are still down on historical levels. Stocks were expensive in January 2000 with an MSCI World price to book ratio of 4.2x. They are trading around 1.8x, after hitting 1.2x in March 2009. The average since 1975 is 2.1x.

There is also dispersion among stocks at the regional and sector level. At the extremes, emerging market equities rose 83 per cent over the past year, whereas Japan posted a very disappointing 6 per cent return in US dollars**.

Among sectors, the global leaders were basic materials stocks, returning 75 per cent, and technology at 60 per cent last year***, while utilities, telecoms and healthcare lagged badly.

In terms of other assets, government bonds only returned 2 per cent in 2009, despite massive quantitative easing purchase programs and ultra-low central bank rates.

For all those investors still holding cash they might want to review their long-term asset allocation.

This is not the only reason why investors could be in for a better period ahead. In a separate historical analysis of previous crises, a third of the 88 banking crises that occurred around the world in the past 40 years had no negative long-term impact on the economy of the country in which they occurred. Indications are that the recent global financial crisis suggest there will be permanent damage.

According to IMF research, an economy suffers a permanent loss of output of 10 per cent for seven years following an “average” banking crisis. However, in about one in three of the cases there was no permanent damage with the economy often ending up in better shape than when the financial crisis started. It is likely policy makers will successfully steer the global economy away from permanent and lasting damage as a result of:

– Near zero interest rates in several developed economies and massive monetary injections to inflate asset prices,
– The largest peace-time fiscal stimulus package in history with almost all countries contributing, especially China, and
– Early recognition of banking losses and forced recapitalisation of the banking system.

As a result, we could see strong growth for years, good profits and, importantly, taxes may not need to rise anything as much as people expect as tax revenues will be strong again.

However, the future is not without risks, as we have seen in recent weeks in Europe. Greece and the associated issues aside, markets will also have to absorb a likely peaking out in the rate of global recovery some time this year and we are also likely to see initial steps to tighten fiscal and monetary policies in many countries. This could result in some choppy waters for investors.

Near-term, we are also seeing a sharp rise in inflation. I see the strongest economic recovery in a generation and that will keep pushing commodities prices higher.

However, looking to the second half of this year or early next year, I think it is unlikely we will have used up all the spare capacity we have in terms of high unemployment and empty factories. If you look at history, when you have had spare capacity, even when there is a recovery going on, inflation tends to drop.

The next few years will be fast moving and, another lesson history shows us, is that in such times flexible tactical asset allocation or diversification across a wide range of asset classes will remain essential.

* Fidelity analysis, January 2010.
** FTSE International, JP Morgan, Datastream, Dow Jones UBS total returns as at 6 January 2010.
*** FTSE World Indices total return as at 4 January 2010.

Trevor Greetham is director of asset allocation at Fidelity International

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