By Michael Baxter 5 Aug 2010 [1 Comment | 803 views]
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A couple of days ago we issued a threat.
We asked the question, Is the stock market overvalued, and said we would take another look at this question shortly, but from a different perspective. Well, we are delivering on that threat.
Perception
Perception matters. If we believe prices will rise, we act in a way that is consistent with this belief, ie we spend our money more quickly and demand higher wages for our work. This in turn can lead to the happening of the very thing we are expecting. In short, our prophecies can become self-fulfilling. By the way, the same principle applies in reverse to deflation.
Clearly the same applies to stock markets. If we expect prices to go up, then we buy, and prices go up as a result. Such reinforcing behaviours can come unstuck eventually, as prices rise to ridiculous levels, then we get crashes, bubbles bursting, and expectations go into reverse.
But supposing our perception is based on false data? We can get a boom, but based on non-existent fundamentals. The end result can be nasty. Pick up any general psychology book and you will come across a chapter on illusion. You will see images of an old lady, who suddenly becomes a beautiful young girl if you change the angle of your view.
And, as most of us must know by now, crowds can get it wrong. That herd instinct can charge bubbles.
Was noughties housing boom built on an illusion?
It has been argued here that such a false view may have developed with UK house prices. At the end of the Second World War, average house price to GDP/capita was low. Wages then shot up over the next few decades. They shot up in part because of inflation, but even in real times they rose dramatically, because the 25-year period that followed the last World War was a golden era for economic growth. Also, during this period home ownership levels more than doubled.
And then we had double digit inflation, a period in which real interest rates – that’s rate of interest minus inflation – were minus for years. In 1975, real rates were minus 12 per cent. Inflation is good news if you are in debt, because the true value of your debt falls every year.
The combination of these factors may have moulded the British public’s view of house prices, creating the expectation of rises in house prices even when the perfect storm of circumstances that promoted the initial boom had blown out. Today we have trivial levels of inflation; wage inflation that lags behind High Street inflation; and home ownership levels that have actually fallen. At current prices, home ownership ratios are likely to fall further still, and while interest rates set by the Bank of England are negative in real terms, for most mortgage holders the interest they pay is much greater than the rate of inflation on their disposable income.
And yet still the Brits have faith in house prices. This is surely the underlying reason why prices went up last year during the midst of the worst recession in 60 odd years.
And that brings us to the stock market.
Was the stock market boom from 1960 to today built on an illusion?
In the noughties they used to say house prices always go up in the long run.
In the nineties they said the same thing about stock markets. (As an aside, why should stock markets go up? The market capitalisation of a company is supposed to be based on that company’s expected future dividends, discounted to give a net current value. If stocks consistently go up, it means markets are consistently getting this forward measure wrong.)
But ignore that rather inconvenient point, and look instead at fundamentals.
Just before the credit crunch, yours truly attended a lecture in which some professor was asking why have stock prices gone up faster than GDP over such an extended time frame. His conclusion is one that is widely accepted by the academic community, and is because the risk premium has gone up.
But why? Why should stocks today be more expensive relative to earnings than stocks sixty years ago? And if stock market growth exceeds economic growth, how can this be sustainable in the long run?
Those who retired on the eve of the dotcom crash, didn’t know how lucky they were. The value of their savings over their working life had been compounded by the rise in risk premium.
According to figures from Moneyfacts, if you had saved £100 per month for 20 years and the money was invested into a balanced management fund, and if you retired at the turn of the millennium, your pension pot should have been worth £103,914, and that should have given you an annual income of £8,998. Now, imagine that your twenty years of saving began ten years later and you are coming up for retirement now. Your savings would be worth £40,749, and the annual income you could expect from that would be £2,542.
But can future generations look forward to better returns?
Last year Robert Buckland, Global Strategist at Citigroup, put out a note saying that before 1960, US equities yielded twice as much as US bonds. He said: “The S&P would need to fall by another 40 per cent to deliver that yield on the current dividend base.”
Mr Buckland reckons it is possible the unusually good period for investment over the last few decades changed investors’ attitude to risk. But this could now reverse. He says: “Since the end of 1999, global equities have returned minus 29 per cent compared to plus 80 per cent return from global government bonds. Not only have equity returns been dire, but the volatility has been brutal. Having two 50 per cent bear markets in one decade is enough to test the patience of the most determined equity cultist. Just as excellent equity returns helped to promote the cult of the equity in the 1950s, so terrible returns seem to be tearing it down now.”
But once again, why? Why did the risk premium rise?
Maybe the answer lies with that magical period of economic growth that lasted from the early 1950s to the mid 1970s, the best era for growth ever recorded. Maybe the boom moulded investors’ perception.
High p/e ratios for stocks became the norm, and when the golden era ended, these new attitudes to risk were so entrenched that investors did not adjust.
So maybe it all boils down to the future of growth.
Globally the economy is now growing at a pace that rivals that golden era.
Will it continue?
As you know, this column is a fan of technology, and believes new technology can provide the foundation for another golden era, even in the West; providing that is, we let it.
But the real point of this story is that in the long run, stock market performance is a reflection of the economy. Risk premium may have a time lag factor built into it. Pensioners who retired in 2000 may have benefited from a delayed psychological effect of the golden era of growth, even though it ended 25 years before their retirement.
And whether the pensioners who retire in, say, 2020 have a better time than the class of 2010, really does depend on economic performance, which itself depends on how we embrace technology. But it also depends on psychology, and the time lags inherent in human nature.
So true. How far will collective optimism allow us to go? Where is the breaking point? I’ve always been amazed at the capacity of the US economy to bounce back, largely I suppose because of the collective optimism of Americans. In contrast, France has been in an almost permanent state of morosity (“la crise” as it’s called) since I arrived here in the mid 1990s.
Collective pyschology presents us with a paradox. We ought to be optimistic, because our expectations can be a self-fulfilling prophecy. On the other hand, if we are not able to detect that we are on an unsustainable path, then we will ultimately be confronted with the most dire of situations–potentially a systemic breakdown.