Many of us can cope with this year’s fall in share prices if it proves to be only temporary, but would feel much more uncomfortable if prices stay low. If you’re one of these people, history has a warning for you: prices can stay below their previous peaks for a very long time.
My chart shows the point. It shows that if we adjust for inflation UK share prices have sometimes spent whole lifetimes below their peaks: I’m taking data from the Bank of England. For example, prices did not return to their 1720 level until 1850, and only returned to their 1909 peak as recently as 1998 – since when, of course, they have slipped back. And it was only in 1989 that prices returned to their 1929 level.
These numbers ignore dividends. Which tells us something important – that over the long run most equity returns come from dividends and from reinvesting them. We cannot rely upon capital gains alone to give us decent long-run returns.
There’s a simple reason for this. Imagine shares were fairly valued so that the ratio of prices to dividends did not systematically change over time. Prices would then rise at the same rate as dividends. And dividends can only grow faster than GDP if the share of profits in GDP rises or if the payout ratio increases – neither of which is likely over the long run. It follows, therefore, that we should expect prices to rise at the same rate as real GDP. And sure enough, this has been roughly true over the very long run. Since 1700 share prices have risen by 1 per cent per year in real terms while GDP per person has risen 0.9 per cent. An average annual rise of 1 per cent, however, leaves plenty of room for sustained long-run falls in prices, given their volatility.
Which poses the question: why does the market recover quickly from some falls but not others?
It depends upon why it falls.
Sometimes, it does so because investors overreact to bad news or because they believe that risk has increased. In practice, it’s hard to distinguish these two reasons. For example, we know in retrospect that prices were low in 2009. But was this because investors thought the risk premium on equities had risen? Or was it because they overreacted to the crisis? It’s hard to tell. For our purposes, though, we don’t need to make the distinction. After falls such as these shares bounce back either as investors correct their error or as they earn the extra risk premium they had priced into equities.
There is, however, a much nastier reason why shares fall sometimes – one that needn’t cause a quick bounce back. Sometimes, they do so because investors learn that future dividend growth will be lower than they previously expected. When this happens, lower prices will reflect lower growth and so there will be no reason for them to recover.
Such downward revisions sometimes happen because investors revise down their earlier over-optimism. In both the South Sea bubble of 1720 and the tech bubble of 1999 growth expectations were too high and so prices fell permanently as those expectations were corrected.
In other cases, though, growth expectations might be cut not because they were egregiously irrational in the first place but because the economic environment genuinely deteriorated. For example, the end of the post-war boom in the 1970s meant that prices stayed below their 1968 peak until 1989.
Which brings us to our current danger. While it is likely that a lot of this year’s fall in prices reflects an increased risk premium that will be reduced as and when a vaccine is rolled out, we cannot rule out the possibility that future growth will be lower than we reasonably expected last year. If so, some of this year’s fall will be permanent.
There are several ways in which this could happen. This year’s recession might have a long-lasting scarring effect upon animal spirits and so reduce innovation and capital spending: why risk expanding if another virus or unexpected event might hit us in coming years? Those of us who have been forced by the lockdown to save more might not return to our previous high-spending habits, while those households and companies forced into debt will repay those borrowings rather than spend even if their incomes do recover. And then there’s the danger of policy error – that the government might tighten fiscal policy unnecessarily.
Of course, these are all dangers rather than certainties. If such fears prove unfounded equities will indeed bounce back hugely – much more so than we’ve seen this week. But we have no guarantee at all that this will definitely be the case. Unless you are willing to take on this risk you should position your portfolio to protect against the danger that prices will remain depressed. For this reason, there is still a case for holding some cash and bonds.
