News

Fighting back after the lost decade

12 February 2009

Why investors should stand firm after ten dreadful years

No-one needs reminding what a difficult decade it has been for equity investors. Two savage bear markets in less than ten years have stretched the patience of all but the most dedicated stock market follower.

This week Barclays Capital published its annual Equity Gilt study, showing that the past ten years have been one of the worst decades on record. For British investors, only the decade leading up to the great stock market slump of 1974 has been worse than the ten years to the end of 2008. And only by a whisker.

In the US, it’s been almost as bad. Only the three overlapping decades ending in 1937, 1938 and 1939 have generated worse returns for investors. In both the US and the UK, the real total return from equities (that’s after accounting for inflation and including the benefit of re-invested dividends) has been negative.

It is hardly surprising, in these circumstances, that people should start to question the value of investing in the stock market. Rumours of the “death of the cult of the equity” abound.

But Barclays’ analysis of its own data in an essay titled “The Lost Decade” shows that far from being gloomy investors should welcome the end of this dismal ten years. That’s because prospective returns – what investors can hope to achieve in future years – are more attractive than at any time in a generation.

If this sounds counter-intuitive, you have to think about what drives share prices. Many investors will think the answer lies somewhere in the reams of macro-economic data that the City pores over every day. If not here then in the quarterly earnings that analysts study in detail and try to forecast.

Both of these are important, but there is a third element that is absolutely crucial – the price you pay for a share. The valuation of a stock at the time it is purchased – whether you measure this with reference to earnings, or dividends, or cashflows or assets – is the major determinant of its subsequent price performance.

Once you understand this, it is easy to see why shares have performed so badly over the past decade. At the height of the dot.com bubble in 1999, shares were more overvalued than they have ever been, in the whole history of the stock market. People were simply paying far too much for their share in the wealth-creating capacity of the companies in which they invested.

What has happened in the nine years since that bubble burst has been a steady unwinding of this excess valuation. The price-earnings multiple which measures it has fallen steadily over that period from a peak of more than 30 to today’s value of around a third as much.

If this is the case, many people will ask, why did shares rise so strongly between 2003 and 2007? The answer is that profits rose even more quickly during that period of illusory earnings growth, fuelled by ultra cheap money and a booming financial sector. The price of shares relative to earnings actually fell throughout the bear market rally.

You might well also ask why shares rose so high during the 1990s. Certainly, the animal spirits of investors – so-called “irrational exuberance” – is one explanation, but Barclays believes it is not the whole answer.

It suggests two other reasons. The first is a dramatic reduction in the volatility of the world economy in the two decades after the turmoil of the 1970s and, especially, a reduction in the corrosive effect of inflation.

This reduction in macro-economic volatility meant investors were prepared to pay a higher price for risk assets like shares, because there was less danger that economic returns would fall. Crucially, it also meant that investors (and non-investors too) were happy to take on much higher levels of debt, which exaggerated the upswing of the economic cycle.

The second reason shares rose in the 1980s and 1990s was demographics. In short, there were relatively high numbers of middle-aged baby boomers squirreling away money in the stock market, which consequently drove share prices higher.

Both of these market positives changed direction in recent years. High debt levels meant that even a relatively small increase in interest rates (in response to the return of commodity price inflation) was enough to puncture the housing bubble which had grown on the back of the Great Moderation in volatility. And the baby boomers started to retire (and so sell the investments they had built up over 20 years).

Neither of these developments is good news for investors looking forward, but Barclays point is that there is a price for everything. Shares have fallen to such an extent over the past “Lost Decade” that the chance of a further de-rating is significantly reduced and the total returns from shares looking forward can be expected to be much better.

This chimes with separate research conducted by Fidelity on Barclays’ data, which shows that every previous decade of negative total returns resulted in a positive return in the subsequent ten years. The average decline in the bad decades was around 3% while the gain in the following years was almost 11%.

Barclays model of likely future returns suggests that investors buying US equities at the close of 2008 will enjoy a nominal (ie before inflation) annualised return of about 13% over the next 10 years.

Who wouldn’t settle for that after the past ten years?

Written by Tom Stevenson – Financial Journalist.