It is well known that the very long run return from equities is of the order of 5 per cent to 6 per cent a year in real terms. What is perhaps less well understood is that this real return tends to be achieved through distinct market cycles measured across multiple years.
Typically there are periods – structural bull markets – where real returns are strong for several years and these are followed by periods – structural bear markets – where real returns tend to be flat at best and highly volatile to boot.
In the UK for example, the years 1969 to 1981 witnessed a structural bear market during which real equity returns averaged -1.8 per cent a year over 13 years. This was followed by a fantastic structural bull market with real returns averaging +13.6 per cent a year over 18 years (1982 to 1999).
This gave way, unsurprisingly; to another structural bear market, which has been running since 2000 and has now completed its 13th year (real returns during 2000 to 2012 have averaged -0.2 per cent a year).
So, with the FTSE 100 having risen close to 100 per cent over the four and a half years since the March 2009 low, and approaching the 1999 peak of 6930, the question of whether we are in a cyclical or structural bull market is important. If we have just experienced a cyclical bull market within an ongoing structural bear phase then, if history is any guide, the good times will likely be coming to an end fairly soon. However, is it possible that we are emerging from a 13-year bear market into a new structural bull market?
Starting valuation is the primary driver of medium-term returns from investments in UK equities (as opposed to GDP growth or corporate profits growth, for example). The primary reason the UK equity market has delivered flat real returns over the last 13 years is because by the end of 1999 the market was on a P/E multiple of 26x and by the end of 2012 the multiple had fallen to 11.5x. The fact that GDP and corporate profits grew strongly during the period was completely overwhelmed by the decline in the P/E rating.
The good news is, given where valuations are today, there is a high probability of strong returns from UK equities over the medium term.
Using data going back to 1970, double-digit annual returns over the coming decade are probable from today’s starting valuation, which should look extremely attractive relative to likely returns from most other competing asset classes.
What will be the key drivers of those multi-year double-digit returns should they come to pass? In the short term we continue to expect recovering economic growth globally to drive further gains in corporate profits, which in turn should support further advances in the equity market. In the medium term I am intrigued by the potential for the valuation on the stock market to rise again, if UK equities show signs of becoming a more popular asset class with investors than they have been generally over the last decade or so.
Assets typically need a compelling ‘story’ to become popular and as we look forward there are several plausible stories that might be advanced in favour of increasing equity weightings again. In no particular order they include: relative value attractions compared to other assets, structural decline in institutional equity ownership that has gone too far, a reasonable hedge against higher inflation than experienced in recent history, some great new technological advances yet to be commercialised.