17th August 2012
It now stands double that at just over 1,400 – by contrast the Footsie (admittedly with over-exposure to banks and volatile mining stocks) has only moved from 3,830 to 5,847, an increase of just 53 per cent.
The New York investment bank calculates that US equity returns over averaged 9 per cent on a 10 year annualised basis since 1880 but less than 5 per cent over the past decade – just 2 per cent after inflation. Besides a plethora of economic fears and realities, demographics are not on the side of share ownership.
Just 70 per cent of the US market is now held, directly or indirectly through pension, mutual and other funds, by individuals. Four decades ago, it was 92 per cent. Pension funds have cut equity exposure from 57 to 39 per cent since the 2008 financial crisis although the US equivalent of personal pensions maintains around 32 per cent of assets in equities. And an ageing population has moved retirement funds into the safe – if low return world – of bonds as it "decumulates". It is little wonder that US media forecast the "death of equities", that "America has fallen out of love with stocks."
Death of equities exaggerated
But, Goldman Sachs says, "we expect better returns over the next 10 years." It forecasts an average annualised return of 8 per cent although it concedes the range could be anything from 4 to 12 per cent.
It reckons the equity pessimism has come at the wrong time – as investors all too often buy at the top and sell at the bottom. It claims US companies are "in terrific shape" with strong balance sheets while earnings and margins are at record levels while return on equity is near its all time high.
At the same time, the below inflation 1.4 per cent yield on US government bonds, the lowest in 130 years, suggests debt has little room to manoeuvre. The investment bank calculates "a greater than 95 per cent probability" that stocks will outperform the benchmark 10 year bond over the years to 2022.
But it warns that it "remains cautious" over the near term. "Europe's fiscal and debt situation is a Gordian knot with no clear solution. Absolute equity returns during the next year will be limited but US stocks offer solid long term performance."
At fund managers Schroders, senior adviser Alan Brown is also a fan of equity revival. His work revolves around the "Dividend Discount Model" which, simply put, states that the value of a company is the discounted sum of future dividends. If this calculation is higher than the current share price, then it is undervalued. And, using this metric, it would appear equities have some way to rise before finding fair value.
End of the affair
At some stage, the love affair with bonds has to end. Just as Goldman Sachs believes that the 130 year historic low on US Treasuries cannot last – others privately compare it to a dotcom bubble but with a gentler burst – Brown states: "It is extremely rare to have negative real yields." He calculates that the last time government bond yields offered so little after inflation was during the 1970s when prices were rising by up to 25 per cent a year.
He adds: "The intrinsic value of government bonds today looks very poor indeed. When the Debt Management Office is contemplating selling us a 100 year bond, we should all be warned!"
Bonds may have ceased to be "risk free assets" and become "return free risk" where buyers see value erode due to negative real yields but with the risk of default or repayment via inflated currencies. By contrast, the real yield on equities "looks historically very cheap".
The biggest role of markets is to provide income in retirement whether through defined benefit (DB) final salary plans or defined contribution (DC) personal pension schemes.
Pensions world faces big questions
Leaving aside the compelling valuation arguments in favour of equities, pensions now need to deal with some fundamental questions.
What is the point of those in their fifties subscribing to so-called "lifestyle" schemes which mechanically migrate money into bonds and cash year by year without any reference to volatility or value?
What is the point of annuities relying on traditional bond portfolios where after costs, pensioners get very little back other than their own money?
And how do the remaining DB funds square the circle of low risk while reducing scheme deficits?
Back to first principles
"There is a need for all involved in pensions including regulators and scheme members to consider these issues, in some cases starting again from first principles. Getting this right can made a huge difference to the retirement outcomes of millions of people. In the meantime, the valuation arguments in favour of equities appear compelling, both in absolute terms and relative to government bonds," Brown concludes.
Goldman Sachs sees some light in the demographic tunnel. There might not be "the avalanche of equity outflow some forecasters fear will occur as baby-boomers retire. A reduction in equity allocation when individuals are in their 60s does not mean stock holdings fall to zero. These assets may be bequeathed to a younger generation, leading to less selling pressure than many believe."
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