If stock market returns have been good in the past, will they be good in the future? Listen to the financial industry and you’d think it was a given. But it isn’t.
The value of a stock is, as John Bogle points out in today’s FT, represented by one thing only: the discounted value of its future cash flow. You pay a price for it now in the expectation that the dividends you will get in the future will make the price make sense.
It isn’t a precise science (obviously) but you can’t get away from the fact that markets have intrinsic values. Now “prices can rise far above their intrinsic values – and far below – but the pendulum eventually focuses on fair value”. The point is that, when you look at markets, the one thing you really have to look at – the only thing that is really important – is price. Everything else is noise.
Bogle looks at the dividend yield in his attempt to see where the value is. Over the past century he says the US has returned nominal returns of around 9% (so before tax, charges and inflation). Half of that has come from capital growth and half from dividends. But today the dividend yield in the US is more like 2% than 4.5% (less than that in Japan…).
So if you expect to get the same kind of return as in the past, you need to think that real capital growth from here on will be higher than it ever has been in the past. I can’t buy that one. Why? Cyclically adjusted p/e. Right now it is knocking around 24 times. In the many years from the late 1800s to 1997 it was at that level for a grand total of 24 months. Since then it has been there most of the time.
You might think that makes some kind of sense given the low interest rate environment we have seen for the past few decades. Perhaps it does. But it also isn’t likely to be sustainable. Overpriced markets are being held up by a mixture of blind hope and quantitative easing. The first is fragile and the second very much at risk: note that while the Fed is allowing itself the option of QE3, it is not a given that it will go ahead.
CLSA’s Russell Napier – who was briefly bullish on equities into the beginning of the year – has recently put out a note suggesting that investors sell their US equity holdings. You can see why.