Shares suffer a negative year - who's worrying?

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The Independent Online

The year is not yet over, and there's still time for that long hoped for rally in stock markets. But with just two trading days to go, it will need to be a spectacular one to stop millennial year entering the history books as one of negative returns for equities - in Britain and just about everywhere else.

The year is not yet over, and there's still time for that long hoped for rally in stock markets. But with just two trading days to go, it will need to be a spectacular one to stop millennial year entering the history books as one of negative returns for equities - in Britain and just about everywhere else.

As it happens, this is not as uncommon a phenomenon as might be thought. It is only the extraordinary bull market of the last six years that has accustomed us to believing markets always go upwards. Before that, the occasional year of negative return was more common. Since the FTSE All Share index came into existence in 1963, there have been nine such years for British equities, or approximately one year in four. And quite a few of them have been a good deal worse than the one we are in right now.

On last night's close, the FTSE All share was showing a fall of nearly 10 per cent on the year, or about the same as was experienced in 1994, the last year of negative returns on equities. Just to put that in context, there was a sickening 55 per cent plunge in the stock market in 1974, when the oil price shock and labour discontent threatened to bring the capitalist world to its knees. Indeed most of these negative years were bunched in the earlier half of the period. In the past twenty years they have become rarer - this will be only the third in that time frame.

But even taking into account these hiccups, UK equities have proved a fabulous investment. Taking the thirty eight years as a whole, the FTSE All Share has shown growth of nearly 3000 per cent, and that's before adding back accumulated dividend income. Inflation makes the figures look a little less flattering, but even taking the rising cost of living into account, the return has been mouthwatering. Since the early 1960s, the FTSE All Share has risen at more than twice the rate of prices. Again, the sensational rates of real return have been concentrated in the last twenty years, which but for a brief interlude in the late 1980s, has been a period of relatively low inflation.

So much for the statistics. What can they tell us about the future? The most important lesson, perhaps, is that over the long term, equities outperform inflation by some distance. No other generally accessible investment has proved as reliably resilient, though obviously to gain the benefit of such resilience requires a constantly adjusted balanced portfolio of different equities.

Unfortunately, there is another, less pleasing lesson. Long periods of above average return such as the one we have just had are eventually and inevitably followed by periods of consolidation or negative returns. Historically, this life cycle has tended to be around 70 years, or about the same as average Western life expectancy. As a rough rule of thumb, the real rate of return on US and UK equities tends to average out at 6-8 per cent over any seventy year period you care to take during the last two and a half centuries.

Bizarre but true, if you had bought a balanced portfolio of equities just before the great crash of 1929, and maintained it ever since, your portfolio would very recently have re-established the long term average for rate of return. But there would have been one hell of a wait for this to happen. Hardly anyone invests on that time frame, not even the big pension funds, and over shorter periods there tend to be big variations. The big issue for investors is whether we have hit afresh one of those periods of prolonged underperformance, that this year will be the first of many marked by poor or negative rates of return, a bit like the 1970s.

Instinct, psychology and the laws of nature might suggest that we have, that after such a long, long stock market boom, there must be a period of correction.

One of those who takes that view is Warren Buffet, the US investment guru, or at least last time anyone was looking he did. Like many bears, he called the turn far too early - several years ago as it happens. But his theory that stock markets go in cycles and that prolonged bull markets require exceptional conditions of economic stability, low inflation and low interest rates, all of which help corporate profits grow at well above average rates, seems eminently plausible.

One of the abiding features of all bull markets, especially those that end in a greed inspired mania, such as the one that engulfed technology stocks up until last March, is that all kinds of weird and wonderful theories are invented to justify them and sustain the belief that unlike all previous periods of speculative excess, they can go on for ever.

This last time round, it was the "New Paradigm" - the belief that a new industrial revolution was taking place, based on communications technology, that would lead to a golden age of low inflation, high growth and improved productivity. The idea, of course, is not without foundation, for it would not have taken hold as it did had it been wholly incredible. There is a New Economy, there is a technological revolution in progress, productivity, in the US at least, has been improving at way above average, and investment has been booming.

None the less, it was always silly to believe this would lead to a suspension of the usual laws of economics. After every boom, there's some sort of a bust. Policy makers have become better at ironing out the peaks and troughs of the business cycle and at keeping inflation on an even keel. There are also fewer truly disruptive wars to interfere with economic progress, and as things stand, little prospect of one.

But the present slow down contains all the usual hallmarks of the day after the night before. The boom in new economy investment has created an overhang of untapped capacity for which there is little if any demand. Lenders and investors are running for cover, as they always do in such circumstances, and businesses across the land are tightening their belts for leaner times, if not yet outright recession.

Quite how bad things get depends as ever on what happens in the US. The super bear position goes something like this. The US Federal Reserve talks of interest rate cuts to help battered nerves, but if the dollar continues to weaken, driving up prices and reversing the inward flow of foreign capital, it won't be able to hold the fort. The strong dollar has kept inflation low and supported an ever burgeoning and ultimately unsustainable trade deficit. Undermine that position, and what we've seen in markets so far may come to seem like only the dress rehearsal.

This column does not believe in the nightmare scenario. US stock markets may well be in for another couple of rocky years if not more, but given the underlying structural strengths of US business and the US economy, and their technological lead, the economic meltdown theories continue to look a little far fetched.

Much easier to believe is that corporate profits are in for a period of sustained pressure. Ironically, one of the reasons for this is the New Economy itself, which through enhanced price transparency makes the business environment more competitive. This in turn may mean that productivity gain is given away to customers, rather than helping to boost profits.

In every cloud, there's a silver lining, and there is a flip side to the period of lower returns on equities we may be heading into; the general mass of the population, helped by cut throat competition in business for the best people and markets, will continue to prosper and get better off, regardless of what's happening to corporate profits and the stock market.

Outlook@independent.co.uk

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