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."

Susan Sarandon described David Bowie as
peopleSusan Sarandon reveals more on her David Bowie romance
Louis van Gaal would have been impressed with Darren Fletcher’s performance against LA Galaxy during Manchester United’s 7-0 victory
Arts and Entertainment
Christian Grey cradles Ana in the Fifty Shades of Grey film
filmFifty Shades of Grey trailer provokes moral outrage in US
The new dawn heralded by George Osborne has yet to rise
voicesJames Moore: As the Tories rub their hands together, the average voter will be asking why they're not getting a piece of the action
newsComedy club forced to apologise as maggots eating a dead pigeon fall out of air-conditioning
Arts and Entertainment
Jo Brand says she's mellowed a lot
tvJo Brand says shows encourage people to laugh at the vulnerable
Rhys Williams
commonwealth games
Life and Style
People may feel that they're procrastinating by watching TV in the evening
Arts and Entertainment
Southern charm: Nicolas Cage and Tye Sheridan in ‘Joe’
filmReview: Actor delivers astonishing performance in low budget drama
Isis fighters travel in a vehicle as they take part in a military parade along the streets of Syria's northern Raqqa province
ebookA unique anthology of reporting and analysis of a crucial period of history
Life and Style
fashionLatex dresses hit the catwalk to raise awareness for HIV and Aids
Life and Style
The veteran poverty campaigner Sir Bob Geldof issues a stark challenge to emerging economies at the Melbourne HIV/Aids conference
Arts and Entertainment
Benedict Cumberbatch and John Malkovich talk Penguins of Madagascar at Comic-Con
comic-con 2014Cumberbatch fans banned from asking about Sherlock at Comic-Con
Arts and Entertainment
Chris Pratt stars in Guardians of the Galaxy
filmGuardians Of The Galaxy should have taken itself a bit more seriously, writes Geoffrey Macnab
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

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

iJobs Job Widget
iJobs Money & Business

The benefits of being in Recruitment at SThree...

£18000 - £23000 per annum + Comission: SThree: SThree, International Recruitme...

Test Analyst - UAT - Credit Risk

£280 - £300 per day + competitive: Orgtel: Test Analyst, Edinburgh, Credit Ris...

Trainee Recruitment Consultants - Banking & Finance

£20000 - £25000 per annum + OTE £40,000: SThree: SThree Group have been well e...

Graduate Recruitment Resourcers - Banking Technologies

£18000 - £25000 per annum + OTE £40,000: SThree: Huxley Associates are looking...

Day In a Page

Backhanders, bribery and abuses of power have soared in China as economy surges

Bribery and abuses of power soar in China

The bribery is fuelled by the surge in China's economy but the rules of corruption are subtle and unspoken, finds Evan Osnos, as he learns the dark arts from a master
Commonwealth Games 2014: Highland terriers stole the show at the opening ceremony

Highland terriers steal the show at opening ceremony

Gillian Orr explores why a dog loved by film stars and presidents is finally having its day
German art world rocked as artists use renowned fat sculpture to distil schnapps

Brewing the fat from artwork angers widow of sculptor

Part of Joseph Beuys' 1982 sculpture 'Fettecke' used to distil schnapps
BBC's The Secret History of Our Streets reveals a fascinating window into Britain's past

BBC takes viewers back down memory lane

The Secret History of Our Streets, which returns with three films looking at Scottish streets, is the inverse of Benefits Street - delivering warmth instead of cynicism
Joe, film review: Nicolas Cage delivers an astonishing performance in low budget drama

Nicolas Cage shines in low-budget drama Joe

Cage plays an ex-con in David Gordon Green's independent drama, which has been adapted from a novel by Larry Brown
How to make your own gourmet ice lollies, granitas, slushy cocktails and frozen yoghurt

Make your own ice lollies and frozen yoghurt

Think outside the cool box for this summer's tempting frozen treats
Ford Fiesta is UK's most popular car of all-time, with sales topping 4.1 million since 1976

Fiesta is UK's most popular car of all-time

Sales have topped 4.1 million since 1976. To celebrate this milestone, four Independent writers recall their Fiestas with pride
10 best reed diffusers

Heaven scent: 10 best reed diffusers

Keep your rooms smelling summery and fresh with one of these subtle but distinctive home fragrances that’ll last you months
Commonwealth Games 2014: Female boxers set to compete for first time

Female boxers set to compete at Commonwealth Games for first time

There’s no favourites and with no headguards anything could happen
Five things we’ve learned so far about Manchester United under Louis van Gaal

Five things we’ve learned so far about United under Van Gaal

It’s impossible to avoid the impression that the Dutch manager is playing to the gallery a little
Screwing your way to the top? Good for Lana Del Rey for helping kill that myth

Screwing your way to the top?

Good for Lana Del Rey for helping kill that myth, says Grace Dent
Will the young Britons fighting in Syria be allowed to return home and resume their lives?

Will Britons fighting in Syria be able to resume their lives?

Tony Blair's Terrorism Act 2006 has made it an offence to take part in military action abroad with a "political, ideological, religious or racial motive"
Beyoncé poses as Rosie the Riveter, the wartime poster girl who became a feminist pin-up

Beyoncé poses as Rosie the Riveter

The wartime poster girl became the ultimate American symbol of female empowerment
The quest to find the perfect pair of earphones: Are custom, 3D printed earbuds the solution?

The quest to find the perfect pair of earphones

Earphones don't fit properly, offer mediocre audio quality and can even be painful. So the quest to design the perfect pair is music to Seth Stevenson's ears
US Army's shooting star: Lt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a military uniform

Meet the US Army's shooting star

Lt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a military uniform