Jonathan Davis: We may be facing a decade of low returns

In the UK, institutions have always adopted a high exposure to the equity markets

As usual, there are interesting and important points in the annual survey of long-term investment returns this week from the broking arm of the investment bank CSFB. This study has been coming out for years under a variety of owners. For a while it became the unofficial bible of those who argued the case for the superiority of equities over all other types of asset class.

This year, not surprisingly, the tone is different. Three consecutive years of falling stock markets have had a significant impact on the long-run case for shares. The authors are notably cautious about immediate prospects. They note that a fourth year of straight decline in the equity indices would be unprecedented, but they are hesitant about saying such an outcome would be impossible this year.

That is clearly the sensible and prudent line to take. It is true that, measured against their trend performance from 1869, equities as a class are no longer still above a fair value trend line, for the first time in years. But there is nothing that says the markets cannot now overshoot on the downside, just as they overshot on the upside during the final years of the great bull market.

You can take out of the historical data any lesson you wish. The truth is that history is only a probabilistic guide to long-term trends, not a predictor. Every generation is different, so it is unwise to assume even the longest and most secure trends will reverse immediately.

The chart this week shows that after their spectacular performance over the last 15 years, gilts are well above their long-term performance trend line in real (after-inflation) terms. For the first time in a long time, it is possible to talk about the possibility of living through a gilts bubble, which must in time correct itself, as the equity markets have had to do so painfully over the past few years. The balance of risk between the two asset classes, which for years has been clearly in favour of gilts, may be reversing itself, though the gilts boom could just as easily last a couple of years first.

But, markets being what they are, driven by the attitudes and sentiments of investors as much as by fundamentals, there is no reason in practice why gilts cannot go on surprising us by producing superior returns over, say, another two years.

There are many reasons, some good, some purely behavioural, why institutional investors are being driven to switch their asset allocation from shares into fixed-interest instruments. It is perfectly plausible, and likely, given the history, that pensions funds and life companies will persist with this switch long after it can be justified on valuation grounds.

As the authors of the CSFB study point out, the factors that drive institutions to change their asset allocation are a combination of things, some behavioural, some regulatory, that may have little to do with investment logic. And the UK has always been a place where institutions have adopted a particularly high exposure to the equity markets, something which they are now trying to unwind.

Pension funds and life assurers continue to dominate the UK equity market, accounting for more than two-thirds of total equity ownership, whereas until the Fifties the markets were still dominated by individual investors. As CSFB point out, institutions have not been dumping shares wholesale: prices would probably have been even lower if they had been. But they have ceased to be the marginal buyer.

This is one reason for taking simple historical extrapolations with a big pinch of salt. It is well known that until the Fifties, investors took it as gospel that equities, as the riskier asset, should offer higher yields than gilts. In the Fifties, this attitude changed and we saw the emergence of the so-called reverse yield gap; since then, bond yields invariably have been higher than equity yields.

Now even that relationship, is no longer so clear-cut. The effect of the bear market, when equity prices fell by an average of 50 per cent over three years, is that the dividend yield on the market is now roughly equivalent to the yield offered by gilts. It is the first time this has been the case in living memory.

On a narrow perspective, that seems to many like a bull signal for equities, and from a medium- to long-term view, it probably is. Investors have never gone badly wrong by buying shares when dividend yields are at their present level. But if you accept that the behaviour of institutions is driven by a wide range of factors, not just by investment fundamentals, it does not follow that they will be leading any reversion towards equities overnight. The other point that comes clearly from the CSFB study is that there are big differences in the returns investors achieved from one decade to the next. There are striking tables in the study that show what would have happened to the real (after-inflation) value of a fund invested in the main asset classes, equities, gilts and cash, from 1869 till now.

In the decade 1979-1989, for example, an equity fund would have grown in real terms more than four times; an equivalent gilt fund would have nearly doubled in value, and a cash fund would have grown by 60 per cent. In the decade 1909-1919, the equity fund would have slightly fallen in value; the gilt fund would have also produced no positive real return, and only cash would have shown an increase (of 20 per cent).

In the coming decade, investors may have to realise the stock market could remain subdued for years, or gilts could produce much less impressive results. We may be faced with a decade of universally low returns, when nothing produces the returns we became accustomed to in the past two decades. The lesson of history is that such an outcome is well within possibility. The good times will return – they always do – but that may require real patience.

davisbiz@aol.com