2000 – 2009 has been a miserable decade for equity investors. Annual returns in Sterling on both the FTSE100 and the MSCI World indices were below 1% in nominal terms and negative after taking account of UK inflation averaging 2.5%. Returns from UK smaller companies a little over 5% per annum but even these were no better than the returns from gilts. A normal expectation would be that equities should earn an annual “equity risk premium” of about 4% over the return on “risk free” government bonds and more from smaller companies.

Research by Legg Mason shows that this is only the second time in history when Wall Street’s returns have turned negative over 10 years (the other was in the late 1930s) but there have been 13 periods since 1871 in which they turned negative in real terms. On average, this created a tremendous buying opportunity with subsequent 10 year real returns above 10% per annum. Investors who were slow off the mark or jumped the gun by being a year late or early were only mildly penalised; they saw returns of 12.3% and 10.1% per annum compared with 13% for those who caught the market at its low point.

 It will pay to remember that Wall Street’s history shows four previous extended periods of consolidation lasting over 10 years; each was followed by an extended period of strong performance.

 Poring over past data as a guide to the future has become a popular pastime and it needs to be remembered that the average of past experience is not a good predictor of the future. The circumstances are different each time and the range of historic outcomes is wide. Nevertheless, fundamental factors support the positive outlook that history indicates: the valuation of markets is reasonable and there is good visibility of strong earnings growth.

It might seem that emerging markets offer the best opportunities; after all, they did not suffer from the problems of over-extended credit, bloated government and inflated expectations which have bedevilled developed economies. Ostensibly, this has already been reflected in a far from miserable decade for emerging markets: the MSCI emerging markets index, excluding income, doubled in the last decade; the Shanghai Composite gained 191%; India’s Sensex 30 rose 226%; Brazil’s Bovespa index rose 314%; and the Russian market 724%.  However, the 1990s had been a very disappointing decade with the bright hopes encouraged by the fall of the Berlin Wall swamped by false starts, legacy problems and a multitude of mistakes. The collapse in emerging markets in the late 1990s left them very cheaply valued and the subsequent strong performance partly reflects performance off a low base.

The disparity between emerging and developed market performance is unlikely to be as stark in the current decade as in the last one but superior economic growth, increasing economic and social stability, high corporate returns of increasing quality and reasonable valuation suggest that returns will still be better for emerging than for developed markets. Smaller companies should also average annual returns a couple of percent above larger companies, in line with the long term trend.

The disparity between emerging and developed market performance is unlikely to be as stark in the current decade as in the last one.

The outlook for government bonds, even assuming fiscal deficits are brought under control, is much less positive. Gilts have returned an annual 5.5% for the last 10 years and the Citibank world government bond index in Sterling 6.6%. The equity risk premium has therefore been -3.9% and -6.4% respectively and it will take a lot of equity performance to return to the long-term trend of +4%. While equities average double digit returns, investors in government bonds are unlikely to do better than collect the yield over the next decade and maybe much less. Investors in quality corporate bonds should do better because yields are higher but the prospects for capital gains are slim.

Developed equity markets are still some 25% below their all time highs. They can rise 10% per annum (equating to a return in the low teens with dividends) for three years before they reach their all time high. By then, markets will have been broadly flat for 13 years and there will be a considerable psychological barrier to break through. It will then pay to remember that Wall Street’s history shows four previous extended periods of consolidation lasting over 10 years; each was followed by an extended period of strong performance.

On an annual basis, performance is likely to be volatile. In the last 36 years, the All Share index has moved by less than 5% (up or down) only five times. It has moved more than 15% 21 times and by more than 20% 14 times. The favourite prediction of most strategists, of single digit returns, is actually very unusual on both sides of the Atlantic. Investors will need to remember that a decade of strong returns will contain some exceptional years but also some negative ones. Patience and nerve will be required at times, but it should be nothing compared to the last decade. This contained, according to the London Business School, two of the worst four bear markets in global equities since 1900, including the worst. It should be much longer than a decade before there is another of similar magnitude.

Peter Waller – Investment Director

(Source: Max King Investment Strategist)

4 March 2010