What’s the point of UK equities? I ask because the 21st century has seen them do very badly. In the past 20 years the All-Share index has risen by barely 7 per cent while the S&P 500 has doubled. And this is in local currency terms: adjusting for the fall in sterling makes the under-performance even worse. Thanks to this, the All-Share index is close to its lowest level relative to the MSCI world index than at any time since 1977.
So, why bother with UK shares?
Efficient market theory says these should be only a small part of our equity portfolios. They account for only 5.4 per cent of MSCI’s world index. If you believe all shares are reasonably priced or (more plausibly) that you are no better than the average investor at spotting mispricings then UK shares should represent this fraction of your developed market equity holdings.
Some economists have gone even further than this. In 1995 Marianne Baxter and Urban Jermann showed that, ideally, investors would have short positions in their domestic stock markets and long ones in overseas ones. This is because if you work in the same country that you invest in you are putting all your eggs into one basket. You are taking the risk that if the economy does badly you will lose on both your wage income and your equity holdings. Going short of domestic equities and long of overseas ones, said Baxter and Jermann, hedges you against this risk.
Of course, it’s impractical for long-term investors to go short. But this points to us holding no UK shares at all.
This argument, however, has been challenged. Princeton University’s Christian Julliard points out that domestic economic failure isn’t the only threat to worker investors. There’s also the danger of incomes shifting from wages to profits. If this happens, he said, domestic equities are a better hedge against falling wages and increased job insecurity than are overseas equities. Working investors should, therefore, hold lots of domestic stocks.
The question for those investors still in work, therefore, is: which risk do we now face? Could we be like Japan in the 1990s, when economic stagnation hit both wages and the stock market and so made overseas equity holdings attractive? Or might we instead be more like the US after 1980 when the stock market soared as many job prospects worsened – in which case domestic equities are a nice hedge against stagnant real wages?
My suspicion is that a combination of Brexit and ongoing secular stagnation means that Japan is perhaps the better precedent. The fact that secular stagnation is a threat to many western economies, however, suggests that we can’t protect ourselves from it merely by holding western equities. It is perhaps a case for investing in emerging or frontier markets.
You might object here there’s a more obvious case for sticking with UK stocks – valuations. The dividend yield on the All-Share index is well above its long-term average, while the cyclically-adjusted earnings yield on the S&P 500 is below its average. Doesn’t this point to the UK out-performing the US, and hence rest of the world?
Partly. It’s true that the dividend yield is a good predictor of future changes in the All-Share index. Since 1985 the correlation between it and subsequent three-year changes in the index has been a hefty 0.69. The post-1985 relationship points to UK equities rising 30 per cent in the next three years, with only a five per cent chance of them falling.
The cyclically-adjusted earnings yield is, however, a weaker predictor of US price changes. You don’t need fancy statistics to know this: the mere fact the S&P 500 has risen in the past three years despite high valuations tells us as much. Post-1985 relationships point to the S&P 500 rising by around 16 per cent in the next three years, albeit with a significant chance (around 30 per cent) of a fall.
Even if this chance materialises, however, it won’t be great for UK shares. These would probably be dragged down by a falling US market – in which case any UK out-performance will come from UK stocks losing us less money. Which is hardly a reason to celebrate.
Perhaps, however, the issue here can’t be settled by statistics. The US market has increasingly been dominated by monopoly-type stocks such as Apple, Microsoft, Alphabet and Facebook. This poses two questions. One is: are investors now paying too much for the virtues of stocks with what Warren Buffett called “economic moats”? Having underpriced monopolies in the past, might they be over-pricing them now? The other is: might such stocks at some time face increased political risk – the threat of a digital tax or even a break-up? In a presidential election year, this question might gain force.
UK stocks, to at least some degree, protect us from these risks. So there is a case for sticking with them. This case, though, is not as strong as the UK’s apparent cheapness would suggest.
