Updated: May 20
It makes sense to me that stocks should produce good real returns over time. A corporation is a clever mix of all the factors of production, namely, land, labour, and capital goods. It also comprises more recently appreciated factors such as entrepreneurship, human capital (education), and intellectual capital (trademarks and technology).
"Selling, or not buying, is always potentially more of a mistake than buying"
Surely, entities that knit all these factors together can provide a better return than say a lump of gold or a government bond?
And, indeed, they have but only if you look over a long enough period. Looking at the US market, representative of stock markets everywhere, stocks’ real rate of return (including dividends) have been around 6.5% per annum since 1870. This is slightly higher than GDP growth over the same period, which is what you would expect, but much more than gold or government bonds.
The problem is that unlike the steady wealth creation associated with GDP growth, returns from stocks are erratic. Although stocks have averaged 6.5% growth per annum over time, a third of the time returns were either better than 25.9% or worse than -12.9%. That was a wild ride even for those with the strongest stomachs.
Furthermore, although stocks most of the time revert to their mean, they also tend to become overbought or oversold. Thus, in 1920, 1932, 1942, 1982 and last year, stocks reached very low levels relative to trend, whereas in 1881, 1902, 1929, 1966 and 2000 the opposite was the case.
The 16 years from January 1966 to July 1982 saw stocks fall 26% in real terms while the 18 that followed it was stellar, with stocks rising 1258%. Today equities are 23% below the long-term trend suggesting we have some upside if, or rather when, markets revert to the mean.
The big question is whether we are halfway through a 1966-82 style bear market that began in 2000 and which will end around 2015 in a similar fashion with the “death of equities” or whether the worst is behind us and we can look forward to equities getting back to trend, which would equate to real returns of around 11% per annum.
As many investors have been brainwashed to fear short-term volatility there is a certain appeal to funds that promise to avoid wild market swings, even if overtime this means missing out on the reliable but irregular 6.5% market return. But 6.5% per annum over time is something not to be sniffed at, even if it is irregular. In fact, 6.5% per annum over 30 years equates to 561%, the difference between living a comfortable and a not so comfortable retirement.
Understandably, given the declines we have seen since mid 2007 and in a number of major markets since 2000, there is some disillusionment with equities.
I would contend that we may well be unaware of the damage being done to economies and markets by fiscal and monetary policy meddling, and that this will at some point be manifested in falling equities, perhaps early next year. But I may be wrong, in which case you will never see these prices again. Indeed, that is why selling, or not buying, is always potentially more of a mistake than buying.
Where will markets go from here in the next few years? Frankly I have no idea. There are too many complex forces at work. But what I do firmly believe is that if you have a time horizon of 10 years or more, then next five years will be a fabulous time to accumulate equities. By 2015 chances are equities will either have reverted to trend in which case you would have made 11% per annum in real terms, or stagnate as they did from 1976 to 1982, in which case you are nicely positioned to profit from what is likely to be a 15 year bull market ending in 2030.
What you have to ask yourself is, do you have the stomach?
Published in the South China Morning Post
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.