Investment: History bears a lesson

Global stock markets continue to be buoyant. This article's author, a market strategist who is based in London and prefers to write anonymously, warns that equities aren't everything
Click to follow
The Independent Online
"IT'S DIFFERENT this time." Sir John Templeton, the famed investment manager, described those words as the most dangerous four words in investment. And yet we never cease to hear them.

We are supposedly in some "new era" of ever-rising prosperity and ever- buoyant stock markets. Most of those managing money have experienced only bull markets, whose only vulnerability has been soaring interest rates. Those interest rates have in turn been driven up by inflationary pressures. But now it has finally become accepted that serious inflation is not likely to be a problem for the foreseeable future. Hence a massive sigh of relief.

Today, US and UK equities stand at all-time records, and the benign inflation environment is a major justification for the supposed "new era". This argument is surely not realistic. The other side of the low inflation coin is that corporate profits will not grow as fast as we have become used to, when inflation was a significant factor. Yet investment analysts in the US expect corporate profits to grow at 12 to 15 per cent for the foreseeable future, even though US GDP is unlikely to grow at, say, more than 5 per cent a year, regardless of technology advances.

It does not take much to realise this does not gel. Over time, corporate profits, despite big swings, tend to mirror GDP growth. And ultimately it is corporate profits that dictate equity market values. If you accept the Federal Reserve's equity valuation model, which relates the yield on US government bonds to US corporate earnings, it suggests US equities are about 45 per cent overvalued. If Wall Street falls substantially it is unlikely other markets would prove immune.

There is no fundamental US economic data suggesting that a long-lasting new era is likely in terms of substantially enhanced economic growth and corporate profits growth. Productivity growth in the US economy has picked up from previous very low levels, but it is still below that achieved in the last golden age - the 1960s - which was itself below the 1920s. Strip out the massive beneficial one-offs that have assisted US reported corporate "earnings" since around 1980, and there has been, in fact, no underlying total economy profits explosion. Just normal cyclical growth. Furthermore, the US was the world's biggest creditor in the 1920s; now it is the biggest debtor, depending on sustained funds from overseas.

Returns earned on shareholders' equity in the US and UK are around record levels, almost universally construed as bullish. But if you understand capitalism you would be bearish, because fat returns in a flexible economy induce competition, as new entrants to the market are attracted by the returns available.

But no one has ever been able to time the end of stock market "bubbles". You have to take it day by day. There are enormous technical and psychological supports to the bull market. The psychology of buying on the dips is massively entrenched. Such psychology is always vital in producing a heavily overvalued "bubble" market.

And, except for three years out of the past 15, corporate directors (often with stock options) have been buying in shares and reducing the supply of available equity, thus supporting prices. This cannot go on endlessly, because there is a limit to the amount of debt that can be incurred in this process. The current US corporate financial deficit is the largest in at least 20 years.

So do we have a "bubble"? Probably yes. I suggest that for market bubbles to form the following circumstances are required: easy money; low inflation, i.e. no threat of major interest rate increases; high share valuations; heavy capital investment; a technology advance and talk of new eras; the belief that it always pays to "buy the dips", that shares ultimately only go up; and investment managers whose only experience is a bull market.

This all sounds familiar, doesn't it? While no one can predict when a bubble will be punctured, a strategic, say 10- to 15-year investor, as opposed to a trader, is probably ill advised to "buy the dips" with leading Western equities, despite the argument that "shares are always the best investment". Historically, for quite long periods, they are not.

A classic example is the past 10 years in Japan, after the deflation of the late 1980s Japanese bubble. The Nikkei index is still down some 55 per cent from its 1989 high. It took 25 years for the Dow Jones to recover its 1929 peak, and six years for the UK market to regain its 1971 level after the 1973-4 slump, (and that is not adjusting for the very high levels of inflation in the 1970s).

It is worth taking a look at fundamentals regarding the US economy and profits. "Productivity" is not a wholly straightforward concept, but official measures are what investors go on. In fact, the first graph shows a long- term downtrend in US productivity growth. In an increasingly service- based economy(manufacturing makes up less than 20 per cent of the US economy), high productivity growth is not possible. In services, such as hotels, restaurants, medical services, there is a limit to how many staff you can cut.

As for US corporate profits, since 1980 or so, these have benefited from substantial one-off benefits: the huge decline in interest rates (now reversing); a large decline in depreciation costs, reflecting plant write- offs and relatively low capital investment (now reversing); and major corporate tax cuts. These factors increased reported earnings by about 50 per cent, an enormous figure, as illustrated by the graph. Underlying total economy profits enjoyed no such joy.

So what can investors do? I do not believe over the medium term significantly higher inflation will be experienced, bar possible late cycle blips. Thus US Long Treasury Bonds, currently yielding 6.0 per cent, seem reasonable value. In the 1960s the US benchmark Government Bond yielded, on average, 4.2 per cent. US "TIPS" - Treasury Inflation Protection Securities - the equivalent of UK indexed gilts, offer some 4 per cent real (ie over inflation) yield. These represent good no- risk returns, except, of course, for the currency risk for non-US investors.

Finally, I have been bullish about Japanese equities for the past year, for almost precisely the opposite reason to my fears about Wall Street, notably minimal profitability which should ultimately go only one way. Patience may be needed but a combination of the way capitalism works and a hardworking, if ageing, population, suggests the risk reward balance in that market is most favourable.

Playing capitalism and markets at their own game implies going the opposite way at market extremes. This is psychologically difficult, but it works, although precise timing is a matter of day-by-day trading appreciation. To be positive, studies by David Fuller, the well-known market technical analyst, suggest in a democratic nation it has always paid to buy shares when markets have fallen some 60 per cent. Japan's Nikkei is still down 55 per cent on its end-1989 peak.

t Jonathan Davis is on holiday