Gurus agree to differ on the risk of a Wall Street crash

News Analysis: The longer US equities continue to rise, the more pessimists predict they are about to plummet, but the truth is that no one really knows

THERE IS one big question at the heart of any discussion of prospects for the world economy: will Wall Street crash?

A lot depends on the answer. If Wall Street topples, European and Asian stockmarkets will follow like dominoes. European shares have been underperforming anyway, but South-east Asian markets have, in the past six months, staged a strong recovery to their pre-crisis levels or beyond and even Tokyo has started to recover.

The longer US equities continue at levels that have made pessimistic pundits uncomfortable for more than two years, the more certain some of them become that a dreadful crash is in the offing. But is this inevitable? Or to turn the question around, what would haveto be true to justify current stockmarket valuations?

There are several approaches to valuing shares. Sushil Wadwhani, the newest recruit to the Bank of England's Monetary Policy Committee used one, the workhorse of equity analysts, to conclude in a recent article that the Standard & Poor 500 index was 20-30 per cent overvalued. Since the article was written, the index has gained another 20 per cent.

The basic formulation says the dividend yield plus the expected real growth in dividends over the long run should equal the real interest rate plus an equity risk premium. In other words, investors equalise the expected real returns from rival assets in the long run - although real-life adjustments are needed, including an adjustment for share buybacks.

Plugging in cautious estimates for the other elements in the formula delivers a stockmarket level considerably lower than it is now. One possible justification for higher valuations is higher prospective dividend growth than the historical average of 1.9 per cent or a higher yield, something that many proponents of the "new economic paradigm" certainly believe.

But as equity analysts are over-optimistic about earnings four-fifths of the time, this seems a slender reed on which to hang massive optimism.

There is scant evidence that a new era of higher productivity is dawning.

Besides, as Mr Wadwhani points out, the new paradigmers explain their optimism on the grounds of increased competition, which would tend to reduce corporate profits. So there is an internal inconsistency in this explanation for high US share prices.

Besides, there is extraordinarily strong evidence that over hundreds of years and in all sorts of stockmarkets, real returns on equity trend towards around 7 per cent. This has been documented for the US by Jeremy Siegel, a professor at the University of Pennsylvania's Wharton Business School. While the real return can vary over shorter periods, over most 50 or 70 year periods it lies in that narrow range. The same is true in the UK back into the 19th century, according to CSFB's Gilt-Equity study, and the bank has also confirmed it for Japan and Germany this century, although with dislocations like the hyperinflation of the Twenties in the latter case.

Although there is no obvious theoretical reason why the number should be 7 per cent, the striking evidence suggests that any period of outperformance will be followed by a period of underperformance.

With the compound rate of real returns on US shares over 13 per cent since 1982, this seems to indicate pessimism about Wall Street is well- founded. Shares are not the most overvalued they have ever been by comparison with this long-run trend, but they are getting close.

Jonathan Wilmot from CSFB notes in a recent report, however, that stockmarket disasters have always resulted from some external shock such as war, the Opec price shock, or the extended policy failures of the Thirties.

Without another shock, real returns on equities will slow towards trend but may be able to sustain that trend for another 20 years or more. The parallel is the 40-year bull run of the mid-19th century, he suggests.

Optimists have another argument, namely that the equity risk premium required by investors has declined. Jeremy Siegel's research also established that, since 1802, equities have outperformed bonds more than two-thirds of the time over five-year holding periods and 99.4 per cent of the time over 30-year holding periods.

Over one year, returns on equity are three times more volatile than returns on bonds but over 20 years slightly less volatile. This suggests that there is no real rationale for an equity risk premium at all. And since the late Fifties, when equity yields famously started to yield more than bonds instead of less, the case has strengthened. The risk of world war looks remote, communism has collapsed, policymakers have learnt how to react to financial crises, inflation is low and growth may be more stable than in the past.

Demographic change could be helping too: if ageing western populations are saving more for their retirement there is higher demand for equities from investors.

The trouble is that all these arguments must be true in order to explain why the apparent risk premium on US equities - although not shares elsewhere in the world - has dropped to zero.

On cautious assumptions it is actually slightly negative.

Michael Hughes, the head of strategy for ING Asset Management, says: "There will not necessarily be a crash but if you are a long term investor you will be better off elsewhere because you are not being paid anything at all to take equity risk."

Mr Wadwhani was equally cautious in his paper. The equity risk premium is about as low as it has ever been and is unlikely to fall further. It might rise, and anyway returns are likely to revert to their long-run trend, he concludes.

Bigger pessimists take a different approach. For example, research by Phillips & Drew emphasises the fact that the growth of the US economy depends on share prices continuing to rise because the expansion is built on declining private saving.

Capital gains make households feel rich enough to spend more than they earn, but without the gains they will stop. Without the economic growth, corporate profits will collapse, which could in turn trigger the Wall Street crash.

The final verdict ought to go to one of the gurus of finance theory, however.

Burton Malkiel, the Princeton professor who wrote the classic A Random Walk Down Wall Street, concluded last year: "I don't think it's possible for even the Almighty to know whether a market is over- or under-valued."

Arts and Entertainment
books
Voices
Caustic she may be, but Joan Rivers is a feminist hero, whether she likes it or not
voicesShe's an inspiration, whether she likes it or not, says Ellen E Jones
Arts and Entertainment
The Doctor and the Dalek meet
tvReview: Doctor Who Into the Dalek more than compensated for last week's nonsensical offering
Sport
Diego Costa
footballEverton 3 Chelsea 6: Diego Costa double has manager purring
PROMOTED VIDEO
Life and Style
3D printed bump keys can access almost any lock
techSoftware needs photo of lock and not much more
Arts and Entertainment
The 'three chords and the truth gal' performing at the Cornbury Music Festival, Oxford, earlier this summer
music... so how did she become country music's hottest new star?
Life and Style
The spy mistress-general: A lecturer in nutritional therapy in her modern life, Heather Rosa favours a Byzantine look topped off with a squid and a schooner
fashionEurope's biggest steampunk convention heads to Lincoln
News
Dr Alice Roberts in front of a
peopleAlice Roberts talks about her new book on evolution - and why her early TV work drew flak from (mostly male) colleagues
News
i100
Arts and Entertainment
Star turns: Montacute House
tv
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
News
i100Steve Carell selling chicken, Tina Fey selling saving accounts and Steve Colbert selling, um...
Arts and Entertainment
Unsettling perspective: Iraq gave Turner a subject and a voice (stock photo)
booksBrian Turner's new book goes back to the bloody battles he fought in Iraq
News
The Digicub app, for young fans
advertisingNSPCC 'extremely concerned'
News
i100
Arts and Entertainment
Some of the key words and phrases to remember
booksA user's guide to weasel words
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Law Costs

Highly Attractive Salary: Austen Lloyd: BRISTOL - This is a very unusual law c...

Network Engineer (CCNP, CCNA, Linux, OSPF, BGP, Multicast, WAN)

£35000 per annum: Harrington Starr: Network Engineer (CCNP, CCNA, Linux, OSPF,...

DevOps Engineer (Systems Administration, Linux, Shell, Bash)

£50000 per annum: Harrington Starr: DevOps Engineer (Systems Administration, L...

Data Scientist (SQL, PHP, RSPSS, CPLEX, SARS, AI) - London

£60000 - £70000 per annum: Harrington Starr: A prestigious leading professiona...

Day In a Page

The other Mugabe who is lining up for the Zimbabwean presidency

The other Mugabe who is lining up for the Zimbabwean presidency

Wife of President Robert Mugabe appears to have her sights set on succeeding her husband
The model of a gadget launch: Cultivate an atmosphere of mystery and excitement to sell stuff people didn't realise they needed

The model for a gadget launch

Cultivate an atmosphere of mystery and excitement to sell stuff people didn't realise they needed
Alice Roberts: She's done pretty well, for a boffin without a beard

She's done pretty well, for a boffin without a beard

Alice Roberts talks about her new book on evolution - and why her early TV work drew flak from (mostly male) colleagues
Get well soon, Joan Rivers - an inspiration, whether she likes it or not

Get well soon, Joan Rivers

She is awful. But she's also wonderful, not in spite of but because of the fact she's forever saying appalling things, argues Ellen E Jones
Doctor Who Into the Dalek review: A classic sci-fi adventure with all the spectacle of a blockbuster

A fresh take on an old foe

Doctor Who Into the Dalek more than compensated for last week's nonsensical offering
Fashion walks away from the celebrity runway show

Fashion walks away from the celebrity runway show

As the collections start, fashion editor Alexander Fury finds video and the internet are proving more attractive
Meet the stars of TV's Wolf Hall... and it's not the cast of the Tudor trilogy

Meet the stars of TV's Wolf Hall...

... and it's not the cast of the Tudor trilogy
Weekend at the Asylum: Europe's biggest steampunk convention heads to Lincoln

Europe's biggest steampunk convention

Jake Wallis Simons discovers how Victorian ray guns and the martial art of biscuit dunking are precisely what the 21st century needs
Don't swallow the tripe – a user's guide to weasel words

Don't swallow the tripe – a user's guide to weasel words

Lying is dangerous and unnecessary. A new book explains the strategies needed to avoid it. John Rentoul on the art of 'uncommunication'
Daddy, who was Richard Attenborough? Was the beloved thespian the last of the cross-generation stars?

Daddy, who was Richard Attenborough?

The atomisation of culture means that few of those we regard as stars are universally loved any more, says DJ Taylor
She's dark, sarcastic, and bashes life in Nowheresville ... so how did Kacey Musgraves become country music's hottest new star?

Kacey Musgraves: Nashville's hottest new star

The singer has two Grammys for her first album under her belt and her celebrity fans include Willie Nelson, Ryan Adams and Katy Perry
American soldier-poet Brian Turner reveals the enduring turmoil that inspired his memoir

Soldier-poet Brian Turner on his new memoir

James Kidd meets the prize-winning writer, whose new memoir takes him back to the bloody battles he fought in Iraq
Aston Villa vs Hull match preview: Villa were not surprised that Ron Vlaar was a World Cup star

Villa were not surprised that Vlaar was a World Cup star

Andi Weimann reveals just how good his Dutch teammate really is
Bill Granger recipes: Our chef ekes out his holiday in Italy with divine, simple salads

Bill Granger's simple Italian salads

Our chef presents his own version of Italian dishes, taking in the flavours and produce that inspired him while he was in the country
The Last Word: Tumbleweed through deserted stands and suites at Wembley

The Last Word: Tumbleweed through deserted stands and suites at Wembley

If supporters begin to close bank accounts, switch broadband suppliers or shun satellite sales, their voices will be heard. It’s time for revolution