Equity risk without a premium?

russell-investments-wire-blog-article-4

My last blog considered a range of plausible return outcomes for a multi-asset fund over the next 10 years and argued that a repetition of the bull run of the last 10 years requires a very constructive view on the equity premium.

This premium is what economists Lubos Pastor and Robert Staunbaugh back in 2001 labelled as “one of the most important but elusive quantities in finance”.

A basket of FTSE 100 stocks bought with your hard-earned cash and spared from the Christmas shopping spree in December 2007 would have lost a third of its value by the end of 2008. By contrast, even in the so called “great bond massacre” of 1994, the worst global bond crisis of the last 30 years, gilt investors lost less than 10%. In some countries investors have been less fortunate, as holders of Argentinean or Greek debt will surely remember, but losses on government bond investments have been relatively modest across most developed markets. Hence equities ought to provide better upside potential than cash or bonds for rational investors to be willing to put their capital at risk. This extra reward is the equity premium.

The traditional view would argue that if you take a short term punt on equities you could end up with either a glorious gain or a catastrophic loss but if you are prepared to hold on for the long term your outcome would become more predictably positive. Long term is a hazy concept and Keynes’ famous quote “in the long term we are all dead” immediately comes to mind. In this context it turns out that the range of possible outcomes is still very wide even if you hold on to equities for as long as 10 years. The chart shows that some unlucky investors in the 1970s and the early 2000s have been rewarded with an equity discount as opposed to a premium.

Luckily enough there is an explanation for this puzzling pattern. When investors overpay for stocks they tend to receive paltry returns, when they pick up a bargain the reverse is true. The price of a dollar of US blue chip profits was 7 dollars in September 1974 (i.e. a PE ratio of 7x) and investors more than trebled their capital in the re-rating that followed in the next 10 years (so enjoyed a 15% annualized return). The price shot up to 31 dollars in June 1999 when I attended one of my first finance courses and everyone rushed to invest in the latest technology fund. Over the decade that followed equity investors not only realized a negative equity premium but actually lost around 20% in nominal terms (and so suffered a -2.5% annualized return).

This leaves us with the million dollar question: what are today’s prices and valuations telling us about the next 10 years? The short answer is that investors extrapolating historical returns will be disappointed unless valuations remain elevated above historical norms. However it is not a uniform picture across markets. My next blog will go through this in more detail.

new-graph-1

Source: Robert Shiller, Global Financial Database, Russell, FTSE. As at 28th February 2015.
Mirko Cardinale, Head of Asset Allocation, EMEA

Mirko-Cardinale

  1. No comments yet.
  1. No trackbacks yet.

This blog is not intended for retail investors. The opinions expressed herein are that of Russell Investments, are not a statement of fact, are subject to change and, unless they relates to a specified investment, do not constitute the regulated activity of “advising on investments” for the purposes of the Financial Services and Markets Act 2000.

This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell product or use any Russell services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation.

Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.

Copyright © Russell Investments 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

The Russell logo is a trademark and service mark of Russell Investments.

Issued by Russell Investments Limited. Company No. 02086230. Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone 020 7024 6000. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS.