With negative news hitting daily, and more yet to come, it's difficult to get optimistic about the stock market and the future of investing.
Over time, however, the economic situation and companies' profits will improve. While it's not clear how fast and how strong the rebound will be, it is clear that this downturn will end - just as it was clear that the previous upturn was also bound to come to an end.
Despite that, it will take investors a long time to overcome the shock experienced during the panic of 2008-09. Evidence suggests that when individuals go through extremely hard financial conditions, it has a lasting negative effect on their willingness to take risks. The result is that government bonds will continue to be overpriced and stocks to be underpriced. For investors with long-term horizons, this could be a golden opportunity.
The massive injection of liquidity and the significant fiscal and monetary policy initiatives and co-ordinated stimulus packages around the globe are already having some effect. The Chinese market is up close to 30 per cent to date this year, the cost of shipping commodities has risen sharply since the start of the year and the key London interbank offered rate has fallen close to 1 per cent, after reaching 4.82 per cent in October and averaging close to 3 per cent for 2008. These are still early signs that could be wrong, but they are signs of light.
So what's next?
Following this crisis, companies around the world will face a healthier economic and financial environment than we have seen in a long time. Companies, fearing that the worst is still ahead, are doing everything to unload costs by aggressively cutting jobs and other expenses. The current global overcapacity will push companies to cut investments and reduce capacity via consolidation through mergers and/or plant closings that will eventually bring supply closer to demand.
A small pickup in demand can then result in large profit increases. And the hoarded cash flooding back into the system will have a beneficial effect on demand as confidence returns.
Companies will have substantial tax-loss carry forwards, which they can use to increase profits by eliminating taxes for several years. Better leadership will also be a beneficial outcome.
True leaders - economic, political and military - rise during times of economic adversity. Finally, improved corporate governance, executive pay and regulation will help put companies and economies on a better footing than they have been for many years.
Will this benefit the stock market and investing in general? Or will investors' experience with the panic of 2008-09 leave them unwilling to take risks for years to come? What does this mean for the future of investing?
A 2007 paper by Ulrike Malmendier and Stefan Nagel at the U.S. National Bureau of Economic Research - entitled Depression Babies: Do Macroeconomic Experiences Affect Risk Taking? - gives us some guidance. They find that investors with higher average stock returns throughout their lives have lower risk aversion and a higher proportion of their investments allocated in stocks.
They report large differences in the average rate of stock market participation between investors from various age groups based on their past experience.
For example, the average rate of market participation for the generation that lived through the 1930s as teenagers or adults was 13 per cent, significantly lower than the rates for all other groups of investors growing up in different periods. Their participation averaged between 26 and 32 per cent.
The study found that in the early 1980s, young investors - having been hurt financially by the disappointing stock market returns of the 1970s - had lower asset allocations in stocks and higher risk aversion than older investors. The bull market of the 1990s changed this behaviour and consequently made young investors report higher allocations into stocks and lower risk aversion than older investors.
If individuals learn from personal experiences of economic events and stock market performance, as evidence suggests, a big disaster like the panic of 2008-09 could have a lasting effect on investors' beliefs, risk aversion and participation in equity markets.
We have already started to see some early evidence on that. For example, in 1952, U.S. pension funds held 17 per cent of their assets in equities. By 1986, the number had risen to 69 per cent. But in 2008, the equity weighting declined to 45 per cent.
Based on the above, what does my crystal ball then see for the future of investing?
Deflation will lead to inflation as governments, normally tending to overshoot, continue the liquidity push as overcapacity is taken out of the markets, and as China and India encourage and stimulate increased domestic consumption.
Investors, having been burnt by recent experiences, will continue to flock to government bonds. Government bonds will continue to be overpriced and a bad investment. The risk premium will remain high. Corporate bonds may be a better investment, but in the presence of rising and accelerating inflation, they may not be a great investment either. The only bonds that will do well in this environment are real return bonds that protect investors against inflation.
And stocks? Lower pension fund and individual investor equity participation will make stocks undervalued and may set the stage for healthy stock returns if one invests for the long run in less-leveraged and well-run companies with a stable cash flow. Moreover, the equity risk premium will return to healthier levels and this will further induce investors to make the move to equities. Those who are brave and bold enough to move into equities or stay for the long run will be rewarded handsomely.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.