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Will equity returns stay high?
The fascinating information on the drivers of returns on equities between the fifties and the nineties dug up by Richard Beddard, has a worrying aspect. Much of the gain came from one-off changes, so returns may not be as good in the future.
According to John Littlewood (as quoted by Richard), profits increased 20× over a period of fifty year (sending in the late nineties), while share prices increased in value by 75×. The market was rerated by a factor of 3.75!
The reason for the rerating was that companies became better at returning money to shareholders, making shares more valuable to shareholders. Now that companies have gone most of the way they can down this road, we cannot expect much more from this. Just how high could the market PE go?
Does this mean that we should not invest in equities? I would say that we should. Remember that even without the rerating, shareholders would still have had the profit increase of 20× and the dividends paid over the years.
Looking to the future, bonds would only outperform equities if interest was greater than earnings growth plus dividends. This does not seem likely to me.
A rough calculation will show why. Assuming that earnings will growth at the long term trend of economic growth. This is unlikely to fall below productivity growth of around 2% and is currently running at nearly 3%. With the market dividend yield close to 3%, equities are likely achieve a real return of 5% or more, significantly better than on bonds.
Another advantage of equities is often forgotten in these times of low inflation. The real value of bonds can fall sharply after a few years of high inflation: shares offer a hedge.
However, the gap is not dramatic, so there is every reason to have some money in both and diversify.Equities will almost certainly do better in the long term, but do not necessarily expect the dramatic returns of some past decades.
Comments(3)
Actually that was my first thought – that it’s a one-off rerating. Littlewood’s book is absolutely compelling and a reminder not to ignore the lessons of history but at the same time not to rely on history repeating itself!
One lesson I draw is that when people say “its different this time”, it is usually a sign that you should be very sceptical. I heard arguments of that nature over the Asian bull market of the 80s/90s and the dotcom bubble. Now I hear the same about house prices…
Incidentally, are you still going to do a rebuttal of my “sucker” post?
[…] riches, it’s financial security. Given our increasing longevity, the cost of living, and doubts about future market returns, I don’t think an index tracker would make enough to give my family security, which moves us […]
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