View from City Road: Puzzle of a bias towards the short term

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The Economic Journal, the plump and authoritative learned journal of the Royal Economic Society, does not normally top City reading lists. But the latest issue should interest fund managers, particularly those concerned that the Chancellor may take another Budget lunge at pension fund tax privileges.

An article by the Bank of England economist David Miles comes near to proving short-termism in the stock market. Since Kenneth Clarke told the Confederation of British Industry last week that this was a particular area of interest to him, institutional investors had better watch out.

All future cash flows are worth less than cash in the hand, because cash today could be invested to reap a future return. A well-functioning financial market would allow for this phenomenon by discounting all future cash flows by a market interest rate each year.

But Mr Miles finds that the stock market undervalues long-run future cash flows: the implicit discount rate applied to cash flows paid after five years is far higher than the implicit discount rate on quicker returns. 'Projects with five years to maturity need to be around 40 per cent more profitable than is optimal,' he says.

This is a puzzle. The difference is not explained by the inherent riskiness of equities compared with bonds, because that risk can largely be offset by spreading investments across a portfolio. The risk in the equity market should not rise sharply after five years.

Two conclusions tentatively follow. If the stock market's short- term bias hampers economic performance, it may be right to make pension fund and life assurers' tax privileges dependent on holding, rather than churning, investments.

The second conclusion is that investors are missing golden opportunities. If Mr Miles is right, there is profit in buying shares with a high expected pay-out in five or more years' time. When those long-term dividends finally become short-term, the share price will go through a dramatic re-rating.