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The end of the cult of the equity Samuel Brittan The Financial Times 07/01/05 There are two culprits for what has gone wrong with pension funds, defined benefit employee schemes and similar investment vehicles. The first is that increasing life spans, which should have been a cause of joy, have taken the statisticians, actuaries, fund managers, civil servants and assorted bureaucrats by surprise. But there is another element too. This is that it has been fashionable to project ahead increasing equity values based on the experience of what is historically a very short slab of time. This habit has by no means come to an end and lies behind a lot of the propaganda to induce people to save more in equity-based funds. This is only the second time I have ventured into discussing the stock market, which is decidedly not my speciality. The first time was on May 13 1999, when I warned that most of the optimistic noises about the Wall Street boom of the time were “nonsense on stilts“. I do so again for a second time - and with a minimum of stock market technicalities - because I fear that the period of ultra-rapid equity growth is over and that this possibility should at least be taken into account by policymakers and investment managers. To try to ground my worries in reality I asked my colleague Keith Fray, of the Financial Times statistics department, to draw up some very long-term charts of leading American and British equity indices. (Keith.Fray@ft.com) The results are enlightening. The starting point is the US because it is the home of the equity. The last century has seen one period of genuine large scale deflation in the early 1930s, a smaller one in the early 1920’s, and many decades of creeping and even galloping inflation. So simply to note that the nominal value of both the Dow Jones and the Standard & Poors indices is about one hundred times what they were at the beginning of the 20th century, takes us nowhere at all. We therefore tried to estimate real indices deflated in the American case by the Consumer Price Index and in the British case, first by the old Cost of Living Index until 1947, and then by the unadorned Retail Prices Index. The results are fascinating and surprising. In the first half of the 20th century, US equities adjusted for inflation showed almost no trend. The Dow Jones average in real terms was in 1950 slightly above the 1900 levels. The Standard & Poors was slightly below. In between there was of course the Wall Street boom of the 1920s followed by the Great Crash of 1929. The US cult of the equity really began in the late 1950s and early 1960s. But many of the gains were subsequently lost during the troubles provoked by the Vietnam war, stagflation and the first oil price crisis. It was not until the Reagan years of the 1980s that the peaks of the 1960s were recovered. After that there was another plateau until the boom or bubble associated with, but no means confined to, IT stocks of the late 1990s. That bubble burst in 2000. We are now left with equity indices in real terms about eight times what they were in mid century and three times what they were in the late 1960s. Not bad. But nothing miraculous nor providing any basis for the “new paradigm“ of which Wall Street optimists, who claimed backing from Alan Greenspan, were inclined to talk. Leaving aside interwar experience, anyone looking into the prospect for the 21st century would have to reckon with the possibility of decades like those from the mid-1960s to the mid-1980s when equities were not even a poor man’s inflation hedge but a trap for the unwary. If we switch attention from the US to the UK we are in for a shock. It is only possible to backdatge the familiar Financial Times Ordinary Share Index to 1930. As might be expected,there were postwar gains extending into the 1950s and 60s. Even so, by the early 1970s the real value of the FT Index was no higher than in the boom year of 1936. After that the Index, measured in real terms, plunged. By the time Margaret Thatcher came to office in 1979 it was below the level of the worst Depression years of the 1930s. It then did indeed recover, but even at its peak in the late 1990s it was still no higher than in 1936. Today it is about the same as it was in 1933 or the darkest days of World War II. So the return for the typical UK equity holder over three generations would have come entirely from dividend payments rather than capital appreciation. It would be difficult to knock down the conclusion that equities have been far from the royal road to growth in the US and no road at all in the UK. The differences between the two countries needs some explanation. It is all too easy to put the blame on Labour governments or British taxes and regulations, But surely there is more to it than that. The inveterate optimists will say that because Britain has done so much worse than the US, there is more scope for British share prices to rise and that, if only Michal Howard were to enter No 10, British equities would suddenly leap up to US levels. The pessimists will say that the economic and financial climate is just not conducive to the cult of the equity even in Britain. Alternatively it might be Wall St that is overvalued. No doubt there is money to be made by those who are shrewd enough to spot medium or short-term fluctuations. The rate of interest used to discount future earnings and dividends can change; so can the equity risk premium. And dividend cover can vary. But these changes can be in either direction and cannot carry on indefinitely. In the very long run the growth of equity values must bear some relation to the growth of the national wealth, allowing as best one can for the overseas elements in portfolios. The growth of national wealth must in turn bear some relation to the growth of national income. If the economy is becoming more capital intensive the former can grow somewhat faster but not without limit. Some conclusions follow from these elementary thoughts. Let us assume reasonable success in the main industrial countries in keeping inflation down to present targets of two or three per cent per annum. Real growth is of a similar order of magnitude. One might therefore expect equity values, to the extent that their behaviour is in line with the underlying economy to rise in real terms by two or three per cent per annum and in nominal terms by four to six pc.,at least as far as the domestic component of portfolios is concerned. The real Standard & Poor’s index has risen by a compound 1.9 pc pa since 1900. The more rapid 4.4 pc real annual growth since 1950 can seen as a catch up after the stagnant first half of the century. It would be rash to reckon on long-term growth in values much above these modest single digit percentages. Of course many standard studies show a higher total return. But they include dividends as well as capital gains on the assumption that all dividends are reinvested. While useful for many purposes, we need to remember that many funds and other holders of securities need to use their dividends as income; and it would be a rare fund that could reinvest everything for a hundred years. In any case it is surely worth trying to study the movement of capital values separately from the dividend return before putting them together. It was ignoring the above very simple macro-economic relationships that led those who a few years ago predicted a rise in the Dow Jones to 36,000 to fall flat on their faces. Up to the 1960s it was expected that a well balanced portfolio would contain a large proportion of short and long dated fixed interest securities as well as land and cash deposits. Today indexed bonds should be added. But there really is no magic in funded equity investment.
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