Michael Baxter: Even our expectations won't produce another golden age for equities
Saturday 21 August 2010
What we expect to happen matters. If we expect house prices to go up, then we become anxious to jump on the property ladder; we spend more money on our house; and buy-to-let landlords are more likely to invest, even if expected yields are quite modest. Built on the foundation of expectations, property prices can then boom, apparently confirming we were right, so fuelling further price rises. It is like that with equities, too.
But suppose our belief is based on a false premise. What if expectations are the only reason why house or share prices are rising. Imagine there is an underlying reason why prices should be lower. This is the stuff that bubbles are made of.
It is possible that we have seen the creation in slow motion of a housing and share bubble, which has been 50 years in the making. But what of equities.
Why is it that, over the course of the 20th-century, equity values rose faster than GDP? Conventional wisdom explains this by saying risk premium has risen. Or to put it another way, we have become more optimistic.
But see share prices in the context of the "Q ratio". This ratio describes the relationship between what the markets think a company is worth, and what accountants reckon the cost of replacing its assets would be. James Tobin, who invented this formula, thought the ratio should be 1. It makes sense, because if the markets believe a company is worth more than the net value of its assets, then it is logical for another company to come along and create the same assets from scratch and then sell out at the higher value determined by the market?
According to Capital Economics, since 1988 British companies have enjoyed a Q ratio of 1.15. Right now, the ratio is around 1.24.
Equity bulls like to talk about p/e ratios, which they say are currently cheap by historical terms. But they are only cheap if you draw comparison with the last two or three decades.
When valuing a company, what really matters is dividends. The market cap is supposed to be based on a formula that takes estimated future dividend flow and discounts it to give a net current value. But has anyone ever bothered to make this calculation retrospectively? Are p/e ratios really a reflection of this future dividend flow?
Take as another example the difference between dividends and the yield on government bonds. Between 1871 and 1960, equities usually provided higher yields than government bonds. Since 1960 the relationship has been the precise opposite, and equities have become more pricey compared to bonds.
The reason for this equity boom could lie in two events: the Great Depression and the Second World War. As the post-war era began, the potential for economic growth was without precedent. The innovations that had occurred over the previous half-century had not been fully exploited for economic gain. The next 25-year period was the golden age for economic growth. We caught up with potential.
We then had a period of high inflation, when interest rates were often significantly lower than inflation. This was not a good time for bond investors. (In 1975, inflation was around 25 per cent, interest rates around 12 per cent.)
Those days are gone. The golden age of growth is over. Few predict a return of 1970s style inflation. But our attitudes were defined in an older era.
Alas, the FTSE 100 still languishes below its all-time high set on 30 January 1999. The Dow Jones is currently around 1,500 points below its pre-dotcom best high set in January 2000. Maybe the bursting of the bubble began 10 years ago.
And whether shares will ever again enjoy another boom like the one they saw in the second half of the 20th-century remains to be seen. It all boils down to whether you believe technological progress will underpin another golden age of growth, or whether we are destined to see anaemic average growth from here on in.
Michael Baxter produces a daily newsletter about the economy at www.investmentandbusinessnews. co.uk. He also co-wrote "Bubbles And Wisdom", published by Asenta
Debt in Britain: Numbers seeking help on how to cope with mounting bills goes up by more than half in three years
General election 2015: David Cameron's promise brings uncertainty to investors
Have a happy new financial year
Are finance apps stealing your personal data?
Simon Read: Frozen in time - the expat British pensioners who deserve a better deal
- 1 Katie Hopkins attacked me on Twitter — so I reported her to the police for inciting racial hatred
- 2 I might be an MP, but that doesn't stop me fighting sexism with my breasts
- 3 Martha Stewart accuses Snoop Dogg of 'smoking for four hours' during Justin Bieber Roast
- 4 Google April Fools': company unveils backwards search engine and huggable digital assistant
- 5 April Fools' Day 2015: The best hoax news stories from around the internet
Ukip supporters are 55 or older, white and socially conservative, finds British Social Attitudes Report
Street preacher quoting from the Bible fined for calling homosexuality an 'abomination'
Woman filmed launching racist tirade against men on the Tube for speaking in 'own lingo'
Katie Hopkins attacked me on Twitter — so I reported her to the police for inciting racial hatred
The West has it totally wrong on Lee Kuan Yew
David Cameron calls Labour 'hopeless, sneering socialists' while announcing 7-day NHS plans
iJobs Money & Business
£20000 per annum + commission: SThree: Sthree have an exciting opportunity for...
£18000 - £32000 per annum: Recruitment Genius: A Telesales Executive is requir...
£45000 - £50000 per annum + benefits : Ashdown Group: A highly successful, glo...
£50,000 - £55,000: Neil Pavier: Are you a professionally qualified commercial ...
Day In a Page
This four-bedroom detached home comes with grounds that span to approximately 2.5 acres, as well as two large patio areas and a double garage.
This four-bedroom cottage is a Grade II-listed town house, well-located for the thriving market town of Nailsworth.
A four-bedroom apartment on the ground floor of a stunning period property in North Yorkshire, with two kitchens and a large south-west facing garden.
This high-spec two-bedroom home is part of a smart collection of new flats at Beaufort Park and has a large decked balcony that's perfect for summer drinks.
Capitalise on the fabulous views of Trevone Bay by taking two homes and creating one spacious boutique B&B. Just a cliff-top walk from Padstow.
Overlooking a golf course, this six-bedroom Edwardian detached home spans four storeys and retains many period features including the original, operational servants' bells...
On the edge of the city, this six-bedroom home comes with an outdoor swimming pool and a large garage block that has annexe potential.
In a Grade II-listed manor just outside of Bath, this three-bedroom home is arranged on two floors with a skylight in a vaulted roof line.
Open the living room's bi-fold wooden doors to reveal a retro-style kitchen, and a conservatory leading to a paved garden at this three-bedroom home.
A Grade II-listed, four-bedroom home, in a charming Somerset village, with a two-storey studio that could be converted into a holiday cottage
A modern four-bedroom Victorian home, within walking distance to the high street
A luxury apartment in the Gothic mansion of Wyfold Court in Kingwood, offers six bedrooms spread over three floors and a turret
This school conversion, near Stockwell Tube, oozes New York loft style. The one-bedroom flat features double height ceilings and exposed brick work
This six-bedroom Georgian home is on three floors with open fireplaces, a two-oven Aga, an annexe, and cottage gardens with outbuildings and a car barn
High Crest House covers an impressive 9384sq ft, with almost three acres of grounds including a tennis court and summer house enclosed by electric gates
A six-bedroom farmhouse with separate accommodation in converted stables. Situated in the village of Church Aston, within walking distance to the market town
A two-bedroom flat with under-heated walnut floors and bespoke built-in storage. The Tube and Clapham Common are a short stroll away
A refurbished seven-bedroom townhouse with staff quarters, cinema room, superb gym, steam room and plunge pool
A minimnalist four-bedroom home designed to the highest spec, featuring glass walls and a kitchen space lit by a glass roof
Hibernate during winter and make your living during the summer at this busy guesthouse with panoramic sea views, in the village of Lynton
A four-bedroom penthouse next to the Tate with direct views of St Paul's from two floors of luxurious living space
A four-bedroom detached home surrounded by spacious gardens and woodland, close to New Pudsey
An 18th-century, three-bedroom home near Langstone Harbour built from ships beams with vaulted ceilings and wood burning stoves
A five-bedroom semi-detached home with a mix of period and modern features in a popular and convenient location
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
A three-bedroom villa with self-contained flat, minutes from Lake Windermere
A five-bedroom Victorian home with four receptions, superb gardens and paddock in Pembury
An eight-bedroom house on the south side of the The Green with cinema, wine cellars and summer house
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park
A state-of-the-art farm-building conversion on the former Cliveden Estate, with 11,420sq ft of internal space, cinema and wine cellar
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads
A boutique mews house, set around a central courtyard, with three bedrooms and a private roof terrace
A four-bedroom farm-conversion with three bathrooms and two reception rooms
A two-bedroom detached house with ensuite bathrooms and a sun-drenched decked terrace, £750,000
A modern and spacious two-bedroom, penthouse flat with two bathrooms in a prestigious development
A beautifully renovated five-bedroom terrace with three reception rooms and a courtyard garden, £700,000
A four-bedroom period house which has been extended to provide almost 2,500sq ft of living space, £675,000
A pretty three-bedroom Georgian home with a 22ft drawing room and a master suite with a balcony, £525,000
A substanstial family home with five bedrooms and landscaped gardens in the much sought-after Branksome Park area
A well-presented three-bedroom house with front and rear gardens, close to White City station, £475,000
A handsome five-bedroom house in a sought-after location close to the city centre
A five-bedroom country home with valley views, equestrian stables and 27 acres of land, £725,000
A six-bedroom farm house with separate, detached cottages and 371 acres of land
A two-bedroom cottage with parquet floors, chunky beams and an open fireplace
A three-bedrrom flat with 2,733sq feet of living space, a beautiful private garden and 15 acres of communal grounds
A four-bedroom chalet bungalow with three bathrooms and a spacious garden, £525,000