Equity investors have had a tough time over the past 12 years. According to the estimable Barclays Equity Gilt Study, the annualised real equity return since the end of the last century is minus 0.9 per cent in the US and minus 1 per cent in the UK. Such returns are pathetic, worse even than cash.
Bond returns, meanwhile, have been outstanding. US Treasuries have delivered a real annualised 6.6 per cent gain over the same period.
Unsurprisingly, this extended phase of weak equity returns has seen the asset class fall out of favour. In the 1990s, UK pension funds held 70 per cent of their assets in equities. Today, they hold just 22 per cent. The key question today is whether equities will continue to underperform in the future.
To answer this question, we need to be quite clear why recent returns have been so poor. The weakness has not been attributable to the trend in corporate profits, but is entirely about the price that investors are prepared to pay for these earnings. S&P 500 earnings per share have increased 75 per cent since 2000, while the S&P 500 price index is unchanged over the same period. Equity markets have delivered feeble returns this century because price to earnings ratios have fallen from the mid-twenties or higher in 2000, to an 8-12 range at present.
Equities started the century at valuations that are associated with low or negative subsequent long run returns. They are now at valuations usually associated with respectably positive long term returns, at least in the continued absence of any of the four horsemen of the apocalypse. This point, however, is not a sufficient basis for piling back into equities. The UK stock market might very well sell today at a multiple of 9.5, but in 1974 it sold at multiple of 3.
To make a stronger case in favour of equities, we have to be convinced that the odds favour an end to the 12 year decline in valuations. There are grounds for believing this to be the case. Contrary to received wisdom, PE ratios are not driven by long term interest rates or inflation. Aside from the lack of any coherent theoretical justification for these supposed relationships, the trends of the past decade or so offer an empirical refutation.
A more coherent and robust explanation is to view PE ratios as a product of two main factors.
Firstly, PE ratios represent the price at which intergenerational transfers of corporate ownership take place. In this sense, PE ratios reflect demographic balances between equity buyers and sellers within the overall population.
Secondly, PE ratios represent a risk premium paid to compensate investors for the uncertainty of the future corporate earnings stream. Part of this uncertainty will reflect microeconomic risks relevant to the company or industry concerned, but a larger part – particularly for the overall market – will reflect macroeconomic risks.
These two factors worked to increase PE ratios in the 1980-2000 period, as economic volatility declined and as the dominant boomer generation aged into their peak equity accumulation years. Subsequently, the boomer generation began to move into retirement and economic volatility rose sharply, both factors working to depress PE ratios.
As best as we can tell, from 2013 onwards, the demographic pressures should ease. The boomers will still move into retirement, but at a much slower pace than recently.
Meanwhile, the shrinkage in the equity buying population will also slow, as the boomers’ children age into their peak equity-buying years. Macroeconomic volatility should also decline. The increased variability of growth and inflation over the past few years has been a product of the interaction between a legacy of high debt and the inflationary tightening of raw material markets due to the emergence of China. Last year’s disappointing economic and equity market performance is a precise example of these effects.
However, debt burdens are now starting to stabilise, with the worst excesses being written off. Meanwhile, China has begun to move towards a less commodity intensive growth model. It is more or less inevitable that the final recovery from the financial crisis will see higher wage inflation erode the real value of the remaining excess debt, allowing a faster deleveraging for households and greater fiscal leverage for governments.
But contrary to the bear argument about peak profits margins, this process will be bullish for equities. Because wage inflation will de-lever and de-risk the system faster, it should lead to a decline in perceived economic risks and a rise in equity valuations. Wage inflation will, of course, devastate bond returns, but it is likely to be a neutral factor for equities. The valuation gap between equities and bonds, which has rarely been as wide as it is right now, offers us a forecast of prospective returns that we would be wise not to ignore.
Tim Bond is investment strategist at Odey Asset Management
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