Investors mesmerised by the heights equities are reaching would do well to take stock of how shares have performed over the long term and whether any lessons can be learnt about the future, particularly in view of the many Jeremiahs forecasting a crash in 1997.
First, the conclusions of the past. It will probably come as little surprise to most seasoned investors that equities have massively outperformed both gilts and cash since the end of World War One, when the BZW study begins. From 1919 to 1996 shares have turned in an inflation-adjusted "real" return of 7.86 per cent a year, against just under 2 per cent for government bonds and less than 1.5 per cent for cash. In the words of Michael Hughes, BZW's head of economics and strategy, investors are being paid a 5.9 per cent premium for the extra risk of holding shares.
This margin looks high, given the history. For one thing, there have been times when cash has hardly been as safe as houses. During the last war it turned in a negative annual return of 2.69 per cent, while anyone who kept their wealth in cash during the decade covering the 1970s would have lost around 28 per cent of it in real terms.
But the risk of holding equities also looks grossly over-stated, at least over long periods. BZW calculates that the chance of equities outperforming both gilts and cash is around 70 per cent over two years, rising to a massive 96 or 97 per cent over 10 years. That said, there have been quite lengthy periods when investors have needed strong nerves: during the late 1930s and the 1970s, shares produced several consecutively negative years, with 1974 recording a whopping 58 per cent loss.
The facts, however, speak for themselves: pounds 100 put into the stock market in 1918 would now be worth pounds 786.30, whereas a similar investment in gilts would have been virtually wiped out, being worth just pounds 3.10 now.
So the first lesson from BZW is that everyone should be in equities if they want to protect their wealth. The second is that, if they can, they should reinvest the income. Ploughing back dividends into the stock market would have turned that same pounds 100 into pounds 36,528 over the past 78 years, with around two-thirds of the return coming from the dividend yield. Including dividends, it means higher rate tax payers have enjoyed a real annual return of 3.9 per cent, comfortably above the average 2.1 per cent growth in the economy.
Clearly, however, wealth is not just for hoarding and most investors do not operate on the three- or four-generation timescale of the BZW study. There are times when selling equities is more profitable in the short term than holding them, so Mr Hughes' conclusion that "investment is more about direction than valuation" seems axiomatic - if an investor knows the direction of the next trend in the market, he can clearly ignore any fundamental valuation methods. But his point is that turning points tend to be dictated by competition for money between the economy and the stock market, which forces up interest rates, rather than any sudden over- or under-valuation in itself.
The $64,000 question is what this means for the market. The current upswing has been running since 1981, according to BZW, when long bond yields topped out. "When you have a very long-term bull market, it's unlikely to end with a whimper. In other words, you get things so overvalued that the correction is normally quite severe," Mr Hughes warns. But he reckons we will not be at that stage until the end of the decade.
As he points out, equities have sustained periods of apparent over-valuation lasting several years in the past. The chart, which shows actual share prices against three different fair valuation methods (plotted in the grey area), suggests London is historically very over-valued.
But valuation is a moving target and the UK has been going through a period of vast secular economic change. Price-earnings ratios, typically ranging between six and 10 in the 1970s, have moved up to between 14 and 18. Likewise, the much-quoted gilt-equity yield ratio was under one until the 1960s, rising to around 2.5 in the early 1970s, before steadily falling in the 1980s. If the Government can sustain its 1-4 per cent inflation target, Mr Hughes reckons it could fall to 1.3 in the future, which would be good news for equities.
And there lies the key. Equities, gilts and cash all perform better when inflation is below its long-term trend, with shares doing particularly well if growth is also above trend. Mr Hughes sees no significant upswing in interest rates on the horizon to upset the apple cart.
His view is not shared by Bob Farrell, chief investment adviser to US investment bank Merrill Lynch. Earlier this month he forecast a major correction in the US market this year. Even if he is wrong, the future direction of equities looks more finely poised than it has been for many years.