Serious Money: Although gloomy commentators have suggested that a drop in equity prices is a matter of when, not if, the reality is a lot less dramatic, writes Chris Johns.
It has become extremely fashionable in recent years to forecast the "death of the cult of the equity". Following on from the great stock market bubble of the 1990s it was, perhaps, inevitable that the three-year bear market that ended in 2003 should be accompanied by gloomy prognostications about the long-run returns to be expected from equities.
In the UK, the charge has been led by the Economist and Financial Times newspapers. For the Economist, the author of the Buttonwood column penned his final thoughts at the end of last month and struck a familiar pose: the rally in equities through 2003 and 2004 has taken valuations back to silly levels.
Indeed, the prices of most risk assets - corporate and emerging market debt in particular - are back to unsustainable levels. Buttonwood argues that another fall, probably a significant one, in equity prices is a matter of when, not if.
The Financial Times has a brace of bearish writers, including the heavyweights Martin Wolf and Samuel Brittan. Mr Wolf has consistently written off the US equity market in recent years and, by implication, most other markets. He has come close to arguing that another stock market crash is all but inevitable.
Given that he is an economist by training, his articles on the outlook for equities inevitably strike a dry, academic pose: lots of stuff about the relationship between profits growth and the economy as well as esoteric discussions of the equity risk premium. Suffice it to say that the outlook is extremely gloomy from Mr Wolf's lofty intellectual chair.
Mr Brittan weighed in with an article last week, similarly writing off the prospects for global stock markets (the US and UK in particular). As with most authors, the arguments are always about valuations and the mis-match between investor expectations for long-run equity returns and what the markets are actually likely to deliver.
Surprisingly, Mr Brittan made a schoolboy error in ignoring the role of dividends in his calculations about past long-run returns from stocks: as every schoolboy knows, stock market long-run history is almost entirely about dividends rather than capital gains.
The valuation arguments are simple enough: stocks, relative to past averages, don't look particularly cheap. In many instances, they still look downright expensive, particularly in the US and technology sectors in general.
The (related) historical argument is also straightforward: the real (after inflation) return on global equities is simply too high - we can assert with absolute confidence that the past will be no guide whatsoever to future returns. The high equity returns of the 20th century are absolutely unrepeatable.
Some numbers illustrate the point. Globally, the annual real return for holding stocks since the beginning of the last century has been 5.7 per cent. In suggesting that the future will be like the past in at least one way, Mr Brittan focused on the historic capital gains from equities, which exclude dividends: globally, stocks have risen, on average, by a mere 1.3 per cent annually, in real terms, since 1900.
The argument is that this is probably the absolute ceiling for expected returns. But Mr Brittan is simply wrong to focus on capital gains rather than total returns, including dividends.
It's a huge number, 5.7 per cent, particularly for the academics who teach that equity returns cannot, over the long-haul, be less than economic growth. That equities have achieved around twice what they should have takes a lot of explaining.
There are two inter-related answers. Firstly, say the learned commentators, a lot of that 5.7 per cent shouldn't have happened and will probably reverse (this is the valuation argument).
Secondly, the factors that might have led some of that 5.7 per cent to be sustainable are utterly unrepeatable.
For example, a lot of it came in the quarter century or so following the end of the second World War - a golden age for growth and profits, something that would never have been expected amidst the ruins of the world economy in 1945 (when, with hindsight, stocks were absurdly cheap).
We are, it is to be hoped, never going to get into a situation when stocks have to recover from the ravages of global conflagration. The best that can be hoped for, from here, is that equities grow in line with economies, which implies a real return of 2.5 per cent.
For our bearish commentators, even this conclusion is too optimistic: such is the current level of over-valuation, stocks will have to fall a long way before they can be realistically expected to deliver that 2.5 per cent annual real return. And it is in the area of expectations that the arguments are most telling.
If people really are expecting the future to be like the past, then our gloomy commentators are probably going to be right. Any individual or institution planning for pensions on the basis of 5.7 per cent annual real returns is in for a shock: returns will be lower than this. But where it is possible to take issue with our pessimistic friends is in the thorny area of valuation and the need for further significant falls in stock prices to restore equilibrium.
I have argued many times in this column that valuation is as much art as science and that anyone who claims omniscience in this area should be treated with suspicion. A little humility is always a good starting point when discussing market valuation: our estimates are often close to guesses.
History can be useful: stock markets typically become inexpensive when there are huge problems in the global economy: markets always look cheap after wars or recessions. Bad global events lead to bad outcomes for stocks. That simple moral is often overlooked by the pundits. Anyone who thinks equities have to become absolutely cheap before we buy them again is essentially forecasting something quite dreadful for the world economy.
Another key lesson from a proper understanding of history is that stock market returns don't usually arrive in smooth little packets: they typically arrive all at once and when you least expect them. Many institutions missed out on the rally of the last couple of years and have learned that being out of stocks can be a costly experience.
Stocks won't spontaneously combust: we are nowhere near the bubble valuations of early 2000. If the world economy muddles through 2005 then so will stock markets - a less attention-grabbing conclusion but, dare I say, a more realistic one.
