Entering 2012, with many geo-political fears on the horizon, equity investors might be expected to lie awake at night worrying about another stock market crash. But that is not what is bothering them at all. Instead, many worry about the possibility of another market rally to match the great rebound that began in the spring of 2009.
This is because the investment managers’ incentives are badly skewed. They are not paid to make money, or even to beat the market. Rather, they are paid not to do worse than their peers. Going down with the market would not be so bad for them; missing out on a rally like in 2009, when stocks doubled in barely two years, would be catastrophic for their career. That is the logic of the way they are paid – usually, as a proportion of their assets under management – and of the way they are judged – against their peers and public stock indices. The result of the investment industry’s misaligned incentives, a contributory factor to the financial crisis which has so far eluded any attempt at a remedy, is that equities enter 2012 looking overvalued. Such mispricing is only likely to lead to misallocation of capital later. In present circumstances, nobody needs that.
It is possible to argue against this. Earnings multiples, the most popular measure of stocks’ value, fell steadily during 2011. At 13 times historic earnings, multiples on the S&P 500 in the US are as low as they have been in two decades, barring a few months during the immediate aftermath of the Lehman Brothers collapse. There is therefore an argument that shares already discount many of the political and macroeconomic fears in the environment.