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
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