This seems a dramatic statement, but it follows from the maths of low valuations.
As I write, the price-earnings ratio on the All-share index is just 8.86. This is almost half its average for the last 15 years, of 17.5. However, the dividend yield is a less exceptional 3.62 per cent – only half a percentage point above its average.
This tells us that firms are hanging onto cash rather than paying it out in dividends. The pay-out ratio is now only 32 per cent, compared to a 15-year average of just over 50 per cent.
But here's the thing. In normal times, you'd expect that firms were retaining so much profit in order to reinvest into their businesses. But this means investors should be anticipating strong growth, as so much money is reinvested. For example, the return on equity for the All-share index has recently been just over 22 per cent. With firms reinvesting 68 per cent of their earnings (100 minus 32), then this implies that future growth should be a whopping 15 per cent a year; 0.221 x 0.68 = 0.15. If share prices were to grow as much as this, we could look forward to total returns of 18.6 per cent – 15 per cent a year plus a dividend yield of 3.6 per cent.
Faced with such returns on shares, and nugatory ones on cash or bonds, everyone would be piling into shares and valuations would be high.
Which, you might have noticed, is not the case.
Something, then, is wrong with this calculation.
One thing is that firms aren’t reinvesting their retained earnings, but are just hoarding cash. Official figures show that, in the year to March, non-financial firms operating in the UK retained £169.5bn of profits after paying taxes and dividends. But only £108bn – less than two-thirds – was invested in capital equipment and new premises. A large chunk of the rest - £31.7bn – was stuck into cash.
One reason for this is that smaller companies especially are not confident that credit will be available if they need it, so they feel the need to hold lots of liquid working capital.
Chris Dillow
But there's another reason why firms aren't investing. It's the same reason why stock markets aren't anticipating future growth – they don't believe that there are good profit opportunities.
Yes, returns on equity have been high recently. But this tells us that past investments were successful. It doesn't tell us that future ones will be. Equity investors and companies are both behaving as if they expect very low future returns on equity.
We can, with a few assumptions, quantify just how low.
Let's say that expected long-run returns on shares will be seven per cent a year. This is an equity premium of 3.1 percentage points over undated gilts – which is in line with estimates of the long-term historic equity premium. 3.6 percentage points of this return should come from dividends, which leaves 3.4 percentage points to come from price appreciation. If we assume that prices rise only because firms expand their operations and profits, then this implies that – with companies retaining 68 per cent of earnings – future return on equity will be five per cent: 0.68 x 0.05 = 3.4 percentage points.
Granted, this is an average. It's dragged down by the fact that a chunk of these retained profits are being invested in cash rather than in real projects. But even so, five per cent is not much. It is half the return on equity made in the last five years by firms such as GKN, Enterprise Inns and Tate & Lyle – stocks not noted for their exciting growth prospects.
What's more, because equity is only part of companies' total capital – the rest being debt – a return on equity of five per cent implies a very low return on capital, of around two or three per cent. This compares to a return of 11.3 per cent now for non-oil, non-financial companies operating in the UK, and is lower than manufacturers suffered in the crises of 1975 or 1981, when huge numbers of them were wiped out.
The market, then, is pricing in a slump in returns on equity and capital.
Which is where Marx comes in. He famously predicted – actually by adapting David Ricardo's law of diminishing returns – that there would be a long-term tendency for the profit rate to fall, and that this would lead both to recession as the motive to invest was extinguished and to bubbles and swindles as people looked for alternative sources of return.
It's a grim prospect. And one on which Marx has been wrong so far. But it seems to be one that businesses and equity investors are anticipating; low future returns on capital are the mathematical result of low expected returns on equities and a high retention ratio.
This leads to one of three possibilities.
One is that future price gains will come not because of corporate growth, but because investors are now exceptionally risk-aversion and so require high expected returns on shares.
A second is that the market is irrationally pessimistic, and shares will soar as or when future investors revise up their expectations for future returns on capital.
The third is that the markets are actually correct.
