For years, investors have believed that equities are a good long-term investment. For a long time, however, this hasn’t been quite true.
My chart shows the point. It shows the gap between annualised total returns on equities versus gilts since each month between 1985 and 2014. It shows that since any month between 1985 and 2000 equities have outperformed gilts by less than 2 percentage points per year. And in fact so far this century equities have underperformed gilts. If anything, these figures might actually overstate equities' performance. I’m measuring gilt returns by the FTSE actuaries index; had you locked in gilt returns by buying a 30-year gilt 30 years ago, the equity premium over gilts would have been even smaller.
Yes, it is the case that equities have done better over the very long term. According to Credit Suisse data, they have outperformed gilts by 3.7 percentage points per year since 1900. But it is only if you had bought at the troughs of the market in 2003 or 2009, or more recently that you would have made such a good excess return.
The idea that equities substantially outperform bonds over the long run is therefore not a current fact but a historical curiosity – much like its exact contemporary, Soviet Communism. (The two might be related, but that’s another story,)
All this poses the question: why has the equity premium been so low in recent years?
You might think it’s simply because there has been a long bull market in bonds that has compressed the gap between equity and gilt returns. This, however, isn’t the whole story. In theory, lower bond yields should mean that investors apply a lower discount rate to future dividends. That should raise share prices. Which means that falling bond yields in themselves should not reduce the equity premium. Instead, the premium has been low in part because of what lower bond yields signify – lower expectations of future economic growth. It is these that have lowered returns on shares relative to gilts, not the bull market in bonds in itself.
There might, however, be another explanation. What we have here might be another example of wising-up risk.
There’s a reason why my chart starts in 1985. Back then, Rajnish Mehra and Edward Prescott published a paper in which they showed that the long-term equity premium up to then had been much bigger than economic theory could justify. Shares, they said, had been a bargain. This gave investors a reason to pile into them. But in doing so they pushed prices up to a level from which subsequent returns have been mediocre on average.
In fact, for much of the time since then the equity premium has been pretty close to what Professors Mehra and Prescott said it should be.
In theory, the premium should be equal to the product of four things: the volatility of equities; the size of our personal financial risks (the greater these are, the less we are able to take on extra risk); the correlation between those risks and the stock market (the more likely shares are to do badly when our other personal finances are suffering the greater must be equity returns to compensate us for this danger); and our risk aversion.
These factors justify an equity premium of only around a percentage point. This is partly because most of us are not terribly averse to risk, and partly because shares sometimes fall when the rest of our finances are doing okay – such as in the early 2000s – which means that equity risk is tolerable and so we don’t need high returns to compensate us for taking it.
But could things change? Many of you expect bond prices to fall at some time. Even if this happens, however, it might not mean that equities outperform gilts by a lot. One reason to fear that bonds will do badly is that monetary policy will tighten around the western world; interest rates will rise and quantitative easing could be reversed in the UK and euro area as well as the US. Such a scenario, however, might well be bad for shares as it might cause a reversal of the “reach for yield” – the process whereby low returns on cash have caused investors to buy shares.
Instead, the best hope for a good equity premium over the longer-term is that secular stagnation would end, and that we’ll get a return to stronger sustainable economic growth. Given the threats of a trade war and hard Brexit, this is however by no means assured.
What we have here is an example of economic theory working well. For years, the long-term equity premium has been in line with what theory says it should be. The fact that an apparent bargain disappeared when it was pointed out in the 1980s is another example of how mispricings disappear once they are pointed out.
Perhaps, therefore, investors should reconcile themselves to the likelihood that the long-term equity premium will remain low.
