Martin Wolf: Long-term equities may disappoint
By Martin Wolf , FINANCIAL TIMES, Last updated: March 21 2006 19:28
What do you conclude if you see a run of blacks on a roulette wheel? Is the next
colour more likely to be black than red, more likely to be red than black, or
equally likely to be either? What about the stock market? If the market has
enjoyed a run of exceptional returns, do you conclude that the prospects are for
continued good returns, for relatively bad returns, or for either equally?
The answer for the roulette wheel is that the future is random. In its strict form,
the efficient market hypothesis would suggest the same is true for stock markets. Investors do not behave
as if they believe this, but rather as if a run of good or bad luck is likely to continue. Precisely because of
such behaviour, the truth is the opposite: a run of relatively good returns is a reason to expect the
opposite. Prices tend to overshoot in the medium term, but oscillate around a mean in the long term.
Technically, as two distinguished financial economists, John Campbell of Harvard and Robert Shiller of
Yale, have shown, returns demonstrate “negative serial correlation”.* They revert to average valuations.
It is generally accepted that investing in stock markets is less risky in the long term than the short term. But,
as Prof Campbell has written, if market returns were draws from the same random distribution every year,
“though the probability of losing money falls with the length of the investment, this is offset by the increasing
size of possible losses over long periods” (my emphasis) (Financial Times, May 10 2002). Only mean
reversion makes stock market investment safer over the long term.
Yet though mean reversion gives, mean reversion also takes away: sometimes it clearly gives bad news.
Now is one of those times. Valuations are not as crazy as they were in 2000. But they still remain very high.
In the case of the US market, two similar measures of fundamental value – “q”, or the valuation ratio (the
ratio of stock market value to the replacement cost of corporate capital), and the cyclically adjusted ratio of
prices to earnings – continue to show exceptionally high values by historical standards (see chart). The post2000 market correction shows why warnings about valuation levels are worth heeding: after all, despite its
recent surge, the US stock market is at the same level, in real terms, as it was about eight years ago (see
chart).
As Andrew Smithers of London-based Smithers & Co shows, the US is not alone. Real returns have recently
been extraordinarily high in the following stock markets: Australia, Belgium, Canada, France, Germany, Italy,
Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.** An average of the annual real
returns (in local currency) over the past 10 to 30 years, on the Morgan Stanley Capital International indices,
ranges from Sweden’s phenomenal 13.7 per cent to Japan’s relatively poor 4.4 per cent, with the US on 8.5
per cent and the UK on 7.3 per cent (see chart). Japan is the only one of these countries not to have
enjoyed higher recent returns than those enjoyed over the twentieth century as a whole. These were
recorded in a wonderful book entitled Triumph of the Optimists.*** The performance of the past three
decades may reasonably be called the “triumph of the super-optimists”.
Improvements in the valuation of underlying assets and earnings explain most of the exceptional returns of
recent decades. But there is little reason to expect valuations to rise on a secular trend. Moreover, when
underlying earnings are valued relatively highly, prospective real returns have to be relatively low, by
historical standards, in the absence of further rises in valuations. To put the point simply, other things being
equal, a cyclically adjusted price/earnings ratio of 10 implies a real return of 10 per cent, while a ratio of 20
implies one of 5 per cent.
Why then have markets been so strong? Many clever people are paid a great deal of money to forecast
short-term movements in markets. Personally, I am sceptical of their ability to do so. But in this case, there
are two reasons why markets have recovered so strongly: high profitability and easy money.
Sources for charts: Smithers & Co; Dimson, Marsh, Staunton; Thomson Datastream
Rises in corporate profitability have been marked in most high-income countries. Cyclical recovery is one
reason. Globalisation is another, since it has generated a worldwide increase in the supply of labour relative
to capital. Profitability may remain high for some time, but it is unlikely to continue to rise from its already
high levels. The weak levels of corporate investment do not suggest any strong belief in the durability of high
returns on capital.
The second explanation is the aggressively expansionary monetary policy that followed the stock market
crash after 2000. Not only were interest rates exceptionally low in the US, eurozone and Japan for a long
time, but there has also been a marked rise in the rate of growth of broad money, from a rate of 4.3 per cent
in the year to February 2004, among members of the Organisation for Economic Co-operation and
Development as a group to 7 per cent in the year to January 2006.
The fact that every asset price is high strongly suggests that the aggressive post-bubble monetary
expansion explains today’s strong equity prices. Safe bonds, risky bonds, equities, gold, property and
commodities are all expensive by historical standards. It is as if markets are expecting both inflation and
deflation. That is not as irrational as it may seem. When asset prices are out of line with incomes, one of two
things is likely: asset prices may collapse (which is deflationary) or incomes may soar (which means
inflation). Markets are betting on both extremes.
So where do stock markets go from here? For the short to medium term I have no idea. But we do know
where they are more likely to go than not in the long term: down. Central banks have worked aggressively to
reflate the post-bubble economies of the high-income countries. Even so markets are still far from their postbubble peaks in real terms. That has certainly reduced the risks of further large falls. But the still high
valuations suggest that risks of disappointment are substantial.
*Valuation Ratios and the Long-Run Stock Market Outlook: an Update, National Bureau of Economic
Research Working Paper 8221, April 2001,www.nber.org; **Past Returns as a Guide to the Future for 15
Equity Markets, March 14 2006, www.smithers.co.uk (restricted distribution); ***Elroy Dimson et al, Triumph
of the Optimists (Princeton University Press, 2002)