UK equity returns have averaged some 5.3 per cent a year since 1900. Those are real returns after inflation, which itself has averaged some 3 to 4 per cent a year over the same period. Although the US market did somewhat better with a 6.5 per cent growth rate and slightly lower inflation.
Markets take their time
Any investor with experience of markets since 2000 should know that returns are not linear. Markets go up and down and so do returns. Less easily remembered, though, is that those market movements take much longer to work through than market commentators like to mention. Since markets are always cheap to sell-side analysts, the reality of 15 to 30-year cycles are too painful to contemplate [see the Investment Spotlight column from January 2016].
But this knowledge is essential to investors who face up to 30 years – or more – of retirement and an income solely based on the successful investment of their lifetime savings. This knowledge is needed even more by those still working and hoping to build their pension pots, net of costs.
Rowing against the tide is always more difficult than allowing it to carry you along, so investors need facts, rather than opinions. At least, if investors are buying into overpriced markets, they should know that their returns will be low.
The Cyclically Adjusted Price/Earnings (Cape) ratio was developed by professor Robert Shiller of Yale University as a means of calculating the over- or under-valuation of US equity markets. As the FT has written, “This measure compares prices with the average of earnings for the previous decade, smoothing out any manipulation of earnings, and accounting for the tendency of p/e ratios to shift according to the profit cycle. Cape signalled the biggest market turning points over the last century, and also correctly showed that the rally after the 2000 dotcom crash was not to be trusted – ending in the great financial crisis of 2008.”
Can Cape be wrong?
But because Cape has consistently indicated that markets have been overvalued since 2000, competing academics have used different metrics to try to prove Professor Shiller wrong. However, another important test is known as Tobin’s Q –named after yet another Nobel prize winner. It compares the value of corporate assets to market prices. This also shows an overvaluation of the S&P.
The importance of the S&P to British investors is that the US accounts for some 55 per cent of world equity markets, as well as being the world’s largest and most important economy. Those clever academics behind the Credit Suisse Global Investment Returns source book have shown that there is no direct correlation between economic growth and stock market returns, yet booming economic times do make investors happier. And happy investors buy shares and spend money.
Central banks and their political masters would love to see such times again, but even negative interest rates are failing to kick-start the world economy. The bankers are now at an impasse while politicians are still reluctant to take the supply side measures they know are necessary, but that voters will hate. Bankers and politicians alike know that during the 20th century the western world became used to rates of economic growth that, in a generation, doubled standards of living.
Riches forever
This notion of material progress is a most powerful and attractive idea but, for it to be delivered, economies need to grow year in and year out. When they do not, or when growth disappoints, as happened in the 1930s and in the past eight years, belief in the idea of progress suffers.
America’s ‘special century’ of growth between 1870 and 1970 was built around five major developments – piped water and urban sanitation; electricity; the internal combustion engine; the telegraph and telephone; and chemicals and pharmaceuticals. In 1870 the average US family lived on less than £700 a year in today’s money, virtually all of which was used for the necessities of shelter, food and clothing. Before the invention of the domestic washing machine, country housewives could spend two days each week washing clothes and needed to walk an average of 148 miles a year to carry 35 tons of water.
The change from the 1870s onwards was break-neck. Living standards were transformed, and life expectancy soared. Radio, the car and electricity created a connected society. By the late 1920s, there were nine cars for every 10 US households, and by 1940 most American homes were recognisably modern, with electricity, indoor plumbing, a gas cooker, fridge and telephone. This took another 30 years to begin to happen in Europe.
We are again hearing of the concept of secular stagnation from economists – a concept of the economic weakness of the 1930s. But 1945 and the end of the second world war ushered in a half century of remarkable global growth, still based on those five transforming technologies. All western nations used GDP statistics to compare their competitive progress with one another, although these were originally developed by President Roosevelt to check on the recovery of the US economy.
Change measurement metrics
GDP measurement was created for a world of goods and not services. Productivity gains from free email, web searching or mapping services are hard to capture in official data, as are those of businesses increasingly investing in intangible, hard-to-measure assets such as a brand, research and development, intellectual property and employee skills, rather than in new factories and machines.
Productivity has slowed in history before revolutionary new technologies were fully understood. The three decades to 1900 used to be known as ‘the great depression’ because growth slowed and employment faltered, but 1890 saw the beginning of electrification, possibly the most important of those five transforming technologies.
There is a risk, too, in extrapolating recent trends into the indefinite future. Growth and productivity may have slowed in recent years, but this could well be a product of the global financial crisis, and not necessary the start of a new slow-growth era. Indeed, few of us can understand the opportunities that digitisation promises.
Less than 35 years ago, IBM introduced the personal computer, costing a couple of thousand dollars and capable of doing much that an IBM mainframe did with its air-conditioned room, a staff of 60 and costs of more than a million dollars. Today, kids play with computers that makes those machines look like very slow dinosaurs, and can connect with the world in a way that also makes the earlier connectivity of radio, electricity and the car seem antediluvian.
Digitisation promises interconnectivity at a personal level that has never existed before, and will remove problems of organisational structure that have plagued society and business since the birth of the industrial revolution two centuries ago. But that is not all; the understanding of the human genome is only the beginning of a medical revolution that will make even the advances of the past century seem like witch doctory.
In such a world, investors must buy equities, however expensive markets may seem. It will take a few years yet, but the developments of the past 20 years will begin to show in business statistics, even though GDP will need to be refined for the new world of digitisation, 3D printing and product customisation. Once they do, all the efforts of the central banks to get inflation going will pay off – and probably rather more than they – or investors –would like.
But the essence of investment success will be buying into low-cost, income-orientated equity funds. Good long-term managers will be needed, and this means that investment trusts have to be the first choice of any investor. Fortunately for them, plenty of necessary facts can be discovered on the websites of AIC and Numis.
