Jonathan Davis: Equity investors should get set for the 6 per cent future

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The idea that equity market returns cannot keep up their spectacular performance over the coming decade now seems to be approaching conventional wisdom. Although the likes of Warren Buffett and Jack Bogle have been saying this for a couple of years, it has taken longer to enter mainstream thinking on this side of the Atlantic.

Yet the idea is given an explicit endorsement in the latest CSFB Gilt-Equity Study, an annual publication which through various incarnations has served as the authorised version of the equity investor's bible for many years. While reaffirming the case for equities as the investment asset of choice for any long-term investor, this year's study acknowledges that the double-digit returns of the last two decades are unlikely to be sustained into the future.

"Despite poor performance seen recently, equity valuations still remain relatively close to their highs," says the firm's strategist, Steve Wright. "The bulk of future returns will, in our view, have to be driven by profit growth. This means that it would be more realistic to look for real returns ... to yield around 6 per cent per annum rather than the 12 to 13 per cent to which investors may have become accustomed."

One reason for this kind of view stems, as the first chart shows, from the 40 per cent of the market's returns over the 20 years 1979 ­ 1999 that came from "valuation expansion" (higher price earnings ratios) rather than from improved fundamentals. There is not room for investors to continue giving higher multiples to shares even if, against all the odds, earnings can continue to grow at their historic rates. Note also how reinvested income, which over the last century has constituted the bulk of equity returns, accounts for just 20 per cent of the total return from equity markets in the past 20 years, and how the story is almost identical for the US, UK and Europe. Another interesting feature of recent experience, summarised in the second chart, is that only rarely have equities, gilts and cash all recorded positive real returns at the same time. On both previous occasions (the last years of the 19th century and the 1920s) such periods have been followed by much less rewarding times. On CSFB's own model, equities remain well above their long-term trend of fair value, even allowing for the setbacks of the last year and a bit.

So much, you may say, is now fairly orthodox stuff, and you would be right. Of course, economic conditions remain broadly favourable and the longer reasonable growth and low inflation can co-exist, the more confident investors will become and therefore the higher the value they will continue to put on what seems to have become a less risky asset.

The lowered risk is an illusion, and a fragile one. You don't have to be a full-time follower of the markets to realise that they have become a lot more volatile since the Nasdaq bubble burst in March last year. This has already resulted in a significant rise in so-called equity risk premium from its previously record low levels. A more interesting question is what the implications of a return to say a 6 per cent per annum average equity return over the next decade could be (and there's nothing to say the outcome could be even lower than this). CSFB's own suggestion is that in such an environment, genuine growth stocks will be rare beasts which will encourage substantial premium ratings and lead to a high level of dispersion of returns within the overall market averages. In other words, those with genuine stock-picking ability could do very well while most other shareholders (and index funds as well) will continue to potter along at an indifferent rate.

I am not entirely convinced by this analysis. It is true by definition that any stock growing at 40 per cent a year would look exceptional in relative terms, the odds of finding such stocks will also by definition be much longer. As many of them already have very high ratings, much of the growth will already be in the price. CSFB is right to say the big gainers are what investors will want, but I fear that experience may prove that consistently superior stock-picking is harder than it looks.

Another suggestion to which I am intuitively more attracted is that the "big is beautiful " phenomenon, a feature of the stock market in the past five years, may be replaced by periods of smaller company out-performance. That, I am sure, will happen for short periods. But remember the real world context; the whole investments business is going to have to contract if 6 per cent a year is the norm. As more brokers and fund managers tighten their belts, it will inevitably lead to less liquid markets and possibly also a measure of capital starvation for even the best small-growth companies.

Much of the divergence in performance between the FTSE 100, FTSE 250 and small-cap indices has little to do with size and a lot to do with the make-up of companies in each index. The ranks of the mid-cap market are still chock-a-block with uninspiring Old Economy stocks in the industrial sector that have been going nowhere for years.

What we still don't know, and probably never will, as I've noted before, is whether we return to more typical equity market returns in a smooth and orderly way, or whether there are some nasty external shocks lying in wait, as there were in the 1930s and 1970s.

Everyone can see where some of these shocks might come from ­ the high levels of indebtedness in both the personal and corporate sectors will almost certainly be one of the catalysts ­ but the route map is not yet clearly marked.

The observation that the faster the markets decline, the further they will then have to rise is true ­ but it is trite.

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