Hitting The Doldrums

13/05/2016 at 4:38 pm

Day after day, day after day,
We stuck, nor breath nor motion;
As idle as a painted ship
Upon a painted ocean.

Thus Coleridge, in his celebrated “Rime of the British Stock Market”.

In 2014 the FTSE 100 index returned +0.7%, a year later -1.3% and over the course of 2016 to date it has delivered -0.8%. One can point to several reasons for this lacklustre performance, notably the commodity markets, the pound and their effect on reported earnings. These are admittedly forecast to pick up this year (though even forward-looking valuations do not look especially cheap on an absolute basis). In any event, to say that it has been a frustrating period for equity investors is to make something of an understatement.

Of course two and a half years barely amounts to a medium term horizon. Like all investors, we know that equities are a long term asset class. They will outperform other types of asset, especially if we remember to reinvest our dividends whenever possible, but will deliver bouts of short term volatility. Hang on in there and those long run returns will begin to come through.

There are, however, some issues with this analysis. Short term bouts of equity market losses have been a recurrent feature of life in the twenty-first century. It started out with the end of the dot-com bubble (three consecutive years of negative returns to the Footsie over 2000-2002). Then there was a peak-to-trough loss of 45%, again on a total returns basis, from October 2007 to March 2009 amid the credit crunch and the Great Recession. The recovery from that low point was soon derailed by the carnage of the sovereign debt crisis in 2011 (total return for the year: -2.2%). There was some brief strength in 2013, and now we are where we are.

Another way of looking at this is to say that from the 31st of December 1999 to the end of March this year, the FTSE 100 index had returned an annualized +2.8%. Uncannily enough, this is exactly the annualized change in value of the Retail Price Index over the same period. Which is to say that over the century to date, the key UK market benchmark has returned exactly zero in real terms.

Is it really the correct response to this fact to dismiss it as a short term effect, and put our faith in long run real returns of 5% – as calculated by the Barclays Equity Gilt Study team – from 1899-2015? (As an aside at this point it is worth noting that Barclays used to cite the arithmetic rather than the geometric mean for forecasting on the grounds that, for various statistical reasons, it provides “the better unbiased estimate”. The arithmetic mean real return to equity is closer to 7% than 5%. While the methodological explanation remains in the 2016 study, however, that 7% “unbiased estimate” is nowhere to be found any more.)

1899-2015. The Long Run. There is something compelling, something authoritative, about this. Nonetheless, a 16-year period of zero real returns is not to be scoffed at either. And that 116-year databank is marked by it too: the real return to UK equity from 1899-1999 was 5.7%. The new century has already wiped almost 1% off the entire long run average.

Look at the 16 years heading into 1999 and the story is very different: stocks averaged a return of +12.6%. Ex out that stellar period from the series and the real return to the asset class (from 1899 to 1983) diminishes to 4.4%. Over the first half of the twentieth century it averaged only a little more than 3%.

In defence of the equity market the FTSE 100 is not at the high-growth end of the spectrum. Since 1999 the mid-cap FTSE 250 has put on over 9% annualized, and so has delivered a real return of +6.2%, which is about what the historic data conditions us to think of as our due.

And yet the 250 is only a fifth the size of the 100 in terms of market capitalization, so it is much less genuinely representative of UK equity as an asset class. Other asset markets do not have to resort to this kind of selectiveness: the IPD UK All [Commercial] Property index shows an annualized total return of +8% for December 1999 to March 2016, the Nationwide index of house prices managed +6.2% (and that ignores rental yield), the gilt market delivered +5.9% and sterling non-government bonds +6.3%. UK investors could have put their pounds to work in any other major asset class – with the single exception of cash – and made a creditable real return. Equity has been, quite simply, appalling.

Past performance is not a guide to future returns . . . and even the Ancient Mariner makes it home in the end. Should the FTSE 100 perk up and hit 7,000 at some point over the next few months things would be feeling very different. But there are sound reasons when looking at expected returns for regarding the 1980s and 90s as the truly anomalous period: the Cold War is not going to end again, nor the internet be invented a second time. Looking further forward one might also note the impact of (developed) world demographics on aggregate demand, and observe that Japan’s stock market has returned an annualized +0.2% over the past 30 years.

The aim of this piece, however, is to raise questions, not to pontificate about any supposed cult of equity. Perhaps, like the Mariner, we should conclude simply by recommending the embrace of diversification.


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