This week marks the first anniversary of the end of the most recent bear market. Between October 2007 and March 2009, the stock markets lost around 54% (using the MSCI World index in euro as a benchmark) before gaining 62% since then. (Mathematical calculations being what they are, an increase of 62% after a slump of 54% means that the markets are still well below their October 2007 level).

There is another anniversary in March, namely the tenth anniversary of the end of the last structural bull market. Between August 1982 and March 2000, the Standard&Poor’s 500 index rose from 102 to 1527, an annualised return of just under 17%. Yesterday, it closed at 1150, which is 25% below its level 10 years ago. During this period, the index went through four cycles:

- a bear cycle:  - 49% between March 2000 and October 2002;

- a bull cycle:  + 100% between October 2002 and October 2007;

- a bear cycle: -57% between October 2007 and March 2009;

- a bull cycle: +68% since March 2009.

The situation looks rather similar for most other industrialised stock markets (the emerging stock markets are mostly above their level of 10 years ago).

The poor performance of equities over the past ten years is not surprising given that at the end of the last century, the stock markets had risen to historically overvalued levels. A commonly-used tool for valuing equities is the price/earnings ratio (PE). A PE of 15 simply indicates that investors are willing to pay 15 times the earnings of a company (in other words, investors would pay 15 million for a company generating annual earnings of 1 million). A more sophisticated variant of the price/earnings ratio is the Shiller PE (after Yale professor Robert Shiller) which, instead of using the earnings of the past year or earnings forecasts for the year under way as denominator, takes average earnings over the past 10 years. The idea is to smooth out earnings over a longer cycle to avoid taking a particularly bad or good year. The very long-term average for the Shiller PE is 16. At the start of 2000, the ratio was 40; it currently stands at around 20. Despite the market's poor performance over the past 10 years, the only time equities were undervalued during this entire period (i.e. in Shiller terms, below its historical average of 16) was for a few months at the end of 2008 / start of 2009.

In light of the above, the idea that equities are cheap after their poor performance of the last 10 years is quite simply not true. After the rally of the past 12 months, equities are once again overvalued and their upside potential for the next three to five years seems very limited from current levels. We could of course argue that the low level of interest rates justifies higher equity valuations and that the history of the stock market shows that equities can remain overvalued for very long time periods. I would be more likely to defend the opposite position, according to which the low level of interest rates reflects the very worrying state of the economy and that argues in favour of below-average equity valuations.

It is customary to say that the stock market anticipates economic recovery and that prices often rise before the economic situation improves. This is true, but the fact of the matter is that since March 2009, the US market has risen by around 70% while the US economy has lost more than 3 million jobs. This kind of situation has not occurred in the past 60 years. Moreover, while economic data for the second half of 2009 were inflated by the governments’ tax boosts and a very favourable comparison effect (to the extent that economic activity practically ground to a halt at the end of 2008 / start of 2009 after the failure of Lehman Brothers), this will not be the case in the coming months. Economic data published in the past few weeks are, in this respect, rather worrying.

What I have said above does not mean that equities should be shunned completely; it is, however, an opportunity to adapt one’s strategy to the kind of market we are in. In a structural bull market, such as the one of the 1980s and 1990s, a passive ‘buy-and-hold’ strategy is justified given that the upward trend of the market is such that in five to 10 years, share prices will sharply increase. In a sideways market, however, an active strategy is required. Our investment strategy in equities continues to be driven by the following points:

 - dynamic management of the percentage invested in equities;

- a structurally increasing weight given to emerging markets (taking advantage of corrections on these markets);

- the identification of segments or companies which are attractively valued or whose outlook is well above the average (after all, the fact that stock market indices are below their level of 10 years ago, has not stopped the share prices of Danone, Nestlé or Procter & Gamble from practically doubling over the same period). Our favourite segments are currently quality companies and companies paying out high and stable dividends (cf. my post of 22 February). Note also that historically, around three-quarters of the equity return has come from dividends.