Hamish McRae: To make sense of the markets we should start by learning the lessons of history

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The Independent Online

It is the job of financial markets to look forward but it is also in the nature of markets sometimes to make mistakes. So the continued dismal performance of stock markets around the world would, on the face of it, be telling us that the economic recovery is not assured. The markets are looking through a dark valley and cannot yet see the golden uplands beyond. But – of course – that could be wrong.

It is the job of financial markets to look forward but it is also in the nature of markets sometimes to make mistakes. So the continued dismal performance of stock markets around the world would, on the face of it, be telling us that the economic recovery is not assured. The markets are looking through a dark valley and cannot yet see the golden uplands beyond. But – of course – that could be wrong.

Anyone trying to make sense of all this ought to start by looking backwards. We are fortunate in the UK in having a study of gilts and equities going back to 1869 – originally done by stockbrokers de Zoete and now carried on by CSFB. The comforting thing to do, when times are hard, is to flip back and see how our present period compares with similar periods of the past.

The first graph makes the basic point that over a long period shares will give a better total return than the two other investments of gilts or cash. If you were to have invested £100 in shares in 1869 and were able to reinvest all the dividends and also update the portfolio as new companies sprang up, then that £100 would be worth roughly £750,000 in real terms. Had the money been in gilts or cash it would be worth £1,000. That is a theoretical calculation, not to be taken too seriously. In the real world little things such as tax and fees intervene. But you see the basic point.

Now focus on the second graph. Despite recent falls UK share prices are still above trend, or at least they were at the end of last year. More about that in a moment. First, note the rising long-term trend of share prices in real terms, which on a 140-year view is really remarkably stable, rising at about 6 per cent a year.

Next, look at the two long periods of solid performance, between 1869 and 1899 and between 1975 and 2000. Both saw a long spell of more or less uninterrupted stock market rises, in both cases moving from roughly one standard deviation below trend to one standard deviation above it.

The first period ended with a period when values moved sideways until the start of the First World War, when unsurprisingly they fell sharply. But by 1929 they were back on trend and actually did rather well through the 1930s. Indeed the only period that was as bad for shares as the First World War was the collapse of the early 1970s. The early 1970s was also the last time when equities fell for two years running – such periods being shaded in the graph.

So what, on this long view, should one say about the last quarter-century? It was clearly very unusual – the best 25-year period of the century. But then the 20th century was, we would hope, an unusual period itself, with the economy shattered by two world wars and the worst inflation in Britain in recorded history.

If we are now still in a "normal" period, such as that at the end of the 19th century, then perhaps the experience then is a more appropriate parallel.

If so, then we could be facing a few more years of a pretty bumpy ride. The UK economy and indeed the world economy might grow quite well, but shares might move sideways as they come back towards the middle band of their long-term trend. If that is right we are a couple of years into a period that could be as long as a decade, when the overall market does not advance a lot. We could expect a couple of good years, then a bad one, then another couple of good ones, then a bad – and so on.

Within this market, some companies will do very well. But you have to find them. So it will be a stock-pickers' market, not an indexers' one. But I think we know that already. If you had had, over the past 18 months, a share portfolio that excluded any high-tech or telecommunications stock you would not have done too badly. And if you had one that was full of "sin" companies, such as tobacco, arms manufacturers and booze, you would have done rather well.

It is also possible that the worst will soon be over. My own guess is that the Footsie will end this year up rather than down, but I would have more confidence in that, were we to have had some more bad news. Paradoxically, you need a sense of despair to spread through the market before confidence can return. The interesting thing about the past couple of weeks has been the widespread acceptance of the proposition that, in market terms at least, there is more bad news to come. It is only when people are expecting bad news that they can be surprised by the absence of it. All you need is neutral news and, hey presto, everyone cheers up.

There do remain, however, two absolutely fundamental questions that have to be answered before you can establish the "several mediocre years, but nothing as bad as we have just been through" thesis.

One is whether the 6 per cent average real return for equities trend is still intact. Could it be too high, or maybe too low?

The best answer to that is that the experience of the past 10 years has taught us that innovation comes in spurts but the productivity gains that stem from that innovation accrue many years afterwards. Ten years ago the browser had not been invented. Now nearly everyone books their low-cost flight on the Net. We are still in the very early stages of the telecoms revolution and it will drive productivity upwards for another generation at least. In so far as rising private sector productivity drives returns it is hard to see such returns dropping below their long-term trend.

Could it be too low? Again, to show that, you would have to demonstrate that something quite outside past experience had happened. There is not really much evidence for that. It may be that competitive pressures are even stronger now than in the past but there are other drags on productivity growth, including the ageing of the population. So let's stick with 6 per cent.

The other question is what effect will the transition from a world of inflation to a world of deflation have? The transition to inflation severely depressed equities through the 1970s (bottom graph); will the transition to deflation in some way distort the investment mix, most obviously by making fixed interest securities relatively more attractive vis-à-vis equities?

My best answer to that is, yes, that will happen. But most of the adjustment has taken place already. Now that long-term government bond yields are in the 5 to 6 per cent range, the scope for a further dramatic fall is limited. There is a danger, albeit small, that the rest of the world could catch the Japanese disease of serious, sustained deflation. Were that to occur then equities outside Japan could suffer the fate of the Tokyo markets. But the danger is surely too small to worry about right now.

Conclusion? The next few years will be like the early years of the past century. Once a bottom is established (my guess is later this year), shares will move forward, albeit in a patchy manner. The time to buy? When everyone really gets worried. But pick good companies rather than following the index.

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