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Fri Dec 31 10:57:44 PST 2004

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IN SEARCH OF A GOLDEN EGG
Dec 29th 2004  

For most of the past two decades, investors have enjoyed double-digit
annual returns. The next ten years look less easy

DURING the past 20 years even a blindfolded monkey with a pin should
have found it easy to make money. Annual total returns (including
reinvested income) on American shares and bonds averaged 13% and 10%
respectively, well ahead of inflation. Dollar investors in British
equities and property did even better, scooping 14-15% (see chart 1).
Today, although inflation is low and interest rates are correspondingly
miserly, investors continue to hope for double-digit returns. They are
likely to be disappointed: the past two decades were exceptional.

In 2004 (up to December 28th) the best performing stockmarkets in
dollar terms (among those tracked by THE ECONOMIST) were Colombia's and
Egypt's, which both rose by more than 100%. America's S&P 500 index
returned a more modest 11%. All too often, though, one year's star is
the next year's dog. It is more informative to look at longer periods.
As chart 2 shows, over the past 100 years American shares have
outperformed bonds, property, art and gold, with an annual average
total return of 9.7%, or 6.3% after inflation. Government bonds
returned less than 5%.

This performance underlies the common view that as long-term
investments shares are hard to beat. History has no doubt helped
investors to live with their losses since the equity bubble burst in
2000. But a lot depends on how long the long term is. In a book in
2002, "Triumph of the Optimists", Elroy Dimson, Paul Marsh and Mike
Staunton of the London Business School found that in 13 of the 16
countries studied, shares did worse than cash in the bank in at least
one 20-year period in the 20th century. Over ten-year periods, negative
real returns on equities were not that uncommon. An investor buying
American shares in 1964 and selling in 1974 would have made a real loss
of 35%.

Another reason for caution is that periods of exceptionally high
returns--such as the 1980s and 1990s--are usually followed by phases of
exceptionally poor performance. The 20-year bull markets in shares
(which lasted until 2000) and in bonds (which continued into 2004) were
fuelled by an almost continuous fall in inflation and hence interest
rates. But now that inflation is low, neither shares nor bonds are
likely to deliver double-digit returns. 

An environment of low and stable inflation is good for economic growth,
says Martin Barnes, an economist at the Bank Credit Analyst, a Canadian
investment-research firm, but it is not so great for financial markets.
Interest rates have now adjusted to low inflation, and bond yields are
near historic lows, so potential capital gains are limited unless
deflation emerges. That implies bond returns in most countries will be
broadly in line with their current yield of less than 5%. 

What about equities? Despite the slump in prices in the three years to
2002, price-earnings (p/e) ratios still look a bit high, notably on
American shares, and share valuations are unlikely to benefit from
falling interest rates in future. Meanwhile, lower inflation means that
the pace of profits growth will slow. Assume that America's nominal GDP
grows by 5% a year (3% in real terms, plus 2% for inflation). If the
share of profits in GDP is constant, profits will grow at the same
rate. However, profits could do much less well, because in America,
Japan and the euro area their share of GDP is close to a record high.
They might well be expected to fall.

Suppose, though, that profits do rise in line with GDP and that p/e
ratios stay the same. Then, Mr Barnes estimates, the total nominal
return on American shares over the next decade will average 6.8% (5%
profits growth, plus dividends), half the figure for the past 20 years.
If profit margins fall modestly and the p/e ratio reverts to its
long-term average, returns will average 4.9%--well below investors'
expectations. Surveys suggest that individuals expect returns of more
than 10%. 

Could property instead lay the golden egg of the next decade? According
to THE ECONOMIST's global house-price indices, housing has yielded
double-digit returns (including rental income) in most countries over
the past 20 years. But the peak may be close. In several countries
house prices are at record levels relative to incomes and rents. At
best, they are likely to flatten off over the coming years. Add in the
sharp fall in rental yields, and the prospective total return on
property over the next five years or so is poor.

The retirement of the baby-boom generation will also start to weigh on
both house and share prices within a decade or so. During middle age,
people tend to acquire assets, such as shares and second homes, as a
future nest-egg. When they retire they sell those assets to the next
generation of investors. With more sellers than buyers, that could push
prices lower. And if older people care more about receiving a steady
income than about maximising gains, they are likely to prefer bonds to
equities, which could dent the relative value of shares.

Average returns of 5% on equities and bonds sound meagre. That said, as
long as central banks keep pumping out liquidity at their current rate,
asset booms and bubbles are always likely somewhere. Commodity prices,
which have surged over the past three years, could keep rising
strongly, thanks to rapidly growing demand from emerging economies,
such as China and India, and to supply constraints. 

Investing in emerging stockmarkets could also pay off handsomely over
the next decade. The average p/e ratio in emerging markets, based on
future expected profits, is around ten, not much more than half of Wall
Street's. To be sure, they are a risky bet: although in 18 of the past
20 years one of these markets has topped the global investment league,
the same market has often collapsed the next year. Over the past 20
years, emerging markets as a group have underperformed Wall Street,
with an average total return of 10.9%. But if governments can maintain
their current, sounder economic policies, growth should be more stable
in the years to come--and returns should be higher and less volatile.

European shares could also outperform Wall Street. The old continent's
economies are widely derided for their rigid markets, high taxes and
lack of entrepreneurial vim. But financial markets have discounted all
this, and European shares look cheap next to American ones. Such is the
gloom about Europe that there is plenty of room for pleasant surprises.

The canny investor who seeks out such opportunities is likely to fare
better than a blindfolded monkey over the next decade. But the most
important lesson for investors is that when nominal GDP is growing by
only 5%, asset prices cannot on average be expected to rise much faster
than this. Anybody wanting a bigger nest-egg will have little choice
but to save more. 

See this article with graphics and related items at http://www.economist.com/printedition/displayStory.cfm?Story_ID=3521037

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