Equities – investment friend or foe?

It is not surprising, therefore, to hear such comments as ‘Markets are uncertain’ and journalists and other ‘experts’ questioning whether capitalism as we know it will cease. Markets are driven by news and such news is random. Stock markets are always uncertain, otherwise there wouldn’t be a return premium for owning equities and we would all own government bonds or cash. In addition, while seeing the value of one’s capital fall and rise wildly can be emotionally uncomfortable in the short term, inflation is arguably the greater threat to long-term financial security and freedom of choice.

Short term forecasting of what will happen to different asset classes is a fool’s errand and is of no benefit to the smart investor. Whenever annual investment returns from equities depart materially from the long term norm this is not usually due to the economics of investing - the earnings growth and dividend yield of companies. Earnings growth has been positive in every moving decade since the 1930s and dividends are always a bonus, not a given. Stockmarket returns are volatile because of the emotions of investors and their willingness to pay a higher or lower multiple for earnings from companies. The price/earnings ratio, as it is known, reflects the swings in investor emotions ranging from greed (high P/Es) to hope (moderate P/Es) to fear (very low P/Es).

Because the bulk of returns from stock markets are based on earnings and dividends, the market has a positive sloping return expectation and in broad terms there is a 3 out of 4 chance of returns being positive in any given year. Therefore, forecasting long-term returns, rather than short term investor sentiment, is actually a much more achievable task. Benjamin Graham, the famous American investor once said “in the short run the stock market is a voting machine... (but) in the long run it is a weighing machine.”

Investment return and speculative returns

John Maynard-Keynes, the famous economist, divided stock market returns into 1) Investment Return – being the dividend yield on equities plus the subsequent earnings growth; and 2) Speculative Return, being the impact of changing P/E ratios on equity prices. Putting the two together gives us 3) Total Return on equities.

So if we assume a dividend yield of 3% and earnings growth of 4.5% we get an expected return of 7.5% for the next 10 years. Let’s assume, say, that the P/E rises from 11 to 15, representing an increase of 36%. Spread over a decade it would add over 3.5% per annum to the return. If, say, the P/E fell to 10 then the return over the following decade would be just under 0.90% per annum less.

Over the last 100 years the average total return on equities of 10.1% was almost the same as investment returns from dividends and earnings growth of 9.90X%. All that speculation only generated an additional 0.20% annual return. But speculation does create many short term variations such as in the tech boom of the late 1990s or the melt down of the early 1970s.

Future return expectations

So how can we use this approach to predict future returns from equities over, say, the next 10 years or more? Nominal earnings growth has historically averaged about 7% per annum depending what time period and market one looks at. If we assume it will run parallel to the growth rate of the economy then over the next 10 years there is no reason not to assume between 4-5% as earnings growth, so I’ll use 4.5% per annum.

Dividends are slightly different and from a high of 6.80% in the late 1970s, when they contributed almost 70%% to the total return, they fell to 2.2%% by the start of this decade, a reduction of almost 70%. The yield on the UK All Share Index is now about 3.5%, as a result of the fall in share values and rising profits, so when added to our growth rate this represents well over 40% of the expected return.

The P/E ratio rose throughout the 1980s and 1990s from a low of 10 (fear) to a high of 25 (greed). There then followed a reduction to the current ratio of 11. Looking forward, which is always the tricky part, it is highly likely that the P/E will ease downward rather than surge upward, so my best guess is that we will see the P/E ratio fall from the current 11 to, say, 10, which is below the historic long term average of 13. This would mean the P/E ratio would fall 9%, equivalent to a reduction in the expected investment return over 10 years of 0.90% per annum. If you have your own ideas on the direction of P/Es then do your own calculations to determine your expected future return using the same formula.

I think it is safe to assume that over the next decade or so we are unlikely to experience the double digit returns of the 1980s and 1990s. A return in the range of 6-8% per annum seems more reasonable but it will probably come with more volatility. So the only certainty about the future is that it is uncertain. There are returns from capitalism that are there for the taking but one needs to focus on the long term trends, not the short term noise. Or put another way, don’t measure the distance between your home and your office with a 6 inch ruler!