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A tale of two dips

Some falls in equities are buying opportunities, but others are not – which is why the market is risky
March 10, 2021

Many of you are happy to take on equity risk because you regard any fall in prices as a buying opportunity. This view might be dangerous.

Granted, it has been correct in recent years, because lower prices and higher dividend yields have indeed led to better returns. Since 1986 the correlation between the yield on the All-Share index and subsequent real three-yearly returns has been 0.64, which means the yield alone has explained over two-fifths of the variation in three-yearly returns. A policy of buying when equities seemed cheap has worked very well.

But it need not always do so. To see why we must distinguish between two different types of fall in prices.

One type occurs when investors over-react to bad news or start to price in the possibility of a nasty event that does not in fact materialise. (Even in hindsight it is difficult to distinguish between these two cases.) When this happens, buying after the fall is a good idea for the more adventurous investor.

Most of the falls we’ve seen in recent years have been of this type – such as the financial crisis of 2008-09 or last spring. This of course is not to say that we can identify the precise bottom of the market. We cannot. But the dividend yield gives us a reasonable clue to when shares are cheap.

There is, however, a different type of fall – one that sees a long-term de-rating of the market.

Historically, these have often happened because of war or revolution. In recent years, though, they’ve come as over-valuations are corrected. Japan’s Nikkei 225 even today is more than 20 per cent below 1989’s level. And if you’d bought Japanese stocks in 1992, after the market had more than halved from its peak, you would still have been sitting on a loss in 2012 – 20 years later. Similarly, if you had bought the Nasdaq composite in the spring of 2000 after the index had dropped 20 per cent, you would not have returned to profit until the autumn of 2013. And if you’d bought the All-Share index in June 2002 after it had fallen by a third you would even now be sitting on no capital growth at all in real terms.

These episodes warn us that equities don’t always bounce back after falls – or at least you can be waiting years for them to do so.

You might object – reasonably, I think – that these examples don’t apply to UK stocks now as these aren’t egregiously over-valued. (Although whether the same can be said for US tech stocks is another matter.)

There is, however, a different threat. To see it, recall a mathematical fact – that the dividend yield is equal to a long-dated bond yield, plus an equity risk premium, minus expected long-term dividend growth.

You might think this alerts us to an obvious danger, that rising bond yields might raise dividend yields and so cut prices. In fact, this is only one problem. Many of the circumstances in which bond yields rise would be ones in which the risk premium falls or expected growth rises.

Instead, a bigger danger is that after a post-Covid bounce the western economy will slip back into long-term stagnation. This could permanently raise dividend yields by reducing expected growth and by raising the risk premium – the latter because lower average growth raises the probability of recessions. We’d also see lower growth expectations and hence higher dividend yields if investors were to come to believe that growth will come from outside of listed companies (many of which are mature ex-growth companies) or if they heed Hendrik Bessembinder’s finding that the typical share actually underperforms cash during its lifetime.

There’s precedent for lower expected growth causing permanent or semi-permanent de-ratings. At the end of 1973 the dividend yield was slightly above its post-1947 average. Equities seemed cheap. But they got a lot cheaper as they were ravaged not just by inflation but by slower growth and heightened uncertainty. Any investor who bought then was sitting on losses six years later.

What is perhaps surprising is that equities are not now pricing in at least some of the risk of prolonged stagnation. This could be because the danger isn’t as significant as I believe. Or it could be because equity valuations have been supported not by a clear-headed view of our long-term prospects but instead by a reach for yield triggered by zero returns on cash.

A sustained de-rating of equities is a non-negligible danger. It is this – much more than short-term ups and downs in the market – that makes equities genuinely risky.