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Investing in shares is a better bet than property

Shares are cheap relative to house prices. History suggests this points to them doing well.
March 23, 2021

UK shares are cheap relative to houses – a fact that is mildly encouraging for equity investors.

Although equities have risen faster than house prices since last spring, the ratio of the MSCI's UK index to Nationwide’s index of house prices is still close to its lowest level since 2009 and well below its post-1973 average.

This matters because the ratio has in the past tended to revert to its mean: when shares have been cheap relative to houses their prices have subsequently risen faster than house prices, and when shares have been expensive they have subsequently fallen relative to house prices. Since 1973, the correlation between the ratio and changes in it over the next three years has been minus 0.45. It would have been stronger than this but for the tech bubble of the late 1990s which saw expensive shares (temporarily!) become even more expensive.

To see why this should happen, let’s go back to basics. We can think of house prices as being like a claim on future wages, because these set a limit upon what we can afford in rents or mortgage payments. And equities are a claim on future profits. When shares are low relative to house prices it is therefore a sign that investors are pessimistic about the growth of profits relative to wages – or, more precisely, about the profits growth of that subset of companies that are listed on the market.

But such pessimism is often unfounded because, as Nicholas Kaldor pointed out in 1957, the shares of profits and wages in national income are stable over time; subsequent events have vindicated this view in the UK but not in the US. As investors have realised that Kaldor was right and they were wrong, they have in the past corrected their pessimism or optimism about profit growth. And so the equity-house price ratio has mean-reverted, at least in the UK.

And here’s the thing. This mean-reversion has occurred much more via share prices than via house prices. Since 1973 the equity-house price ratio alone has explained almost one-fifth of the variation in three-year changes in share prices but only 3 per cent of the variation in house prices.

 

 

In other words, stock markets are more prone to over-react than housing markets – or at least to correct this over-reaction within three years.

Which is good news for equity investors. If the post-1973 relationship continues to hold, it points to the All-Share index rising over 35 per cent in the next three years, with only around a one-in-seven chance of it being lower in 2024 than it is now.

This is not the only bullish indicator for equities. Retail sales have recently been high relative to equities, a fact that has in the past predicted better economic times and hence good returns on equities.

As you might imagine, though, there are caveats to this. The problem here is not that interest rates might well rise over the next three years. Sure, higher rates in themselves could be bad for equities. But some of the circumstances in which rates rise – such as stronger economic growth – are good for shares. And anyway, it’s difficult to see that rising rates are more of a problem for equities than for house prices.

Instead, another concern is that the dividend yield on the All-Share index, at under 3 per cent, is below its long-term average – a fact that in the past has been a hugely powerful predictor of below-average returns. Yes, this is partly due to last year’s cuts in dividends by big oil and banking firms. But even so it is a warning sign that the resumption of dividends is now priced in, which removes one reason for optimism. Worse still, it means equities are vulnerable to the danger that investors might come to fear that longer-term growth will be weaker than they now expect.

There’s another confounder for any investor facing a choice between equities and housing as an investment. It’s that the housing market, more than equities, could get government support in the form of yet another extension of the stamp duty holiday or more 'help to buy' schemes (the latter of course are more help to existing home-owners and housebuilders than they are to prospective buyers). We used to speak of the 'Greenspan put', or 'Bernanke put' or 'Yellen put' as supports for US equities. Perhaps we should think of UK house prices as being supported by a 'Sunak put'.

Even with these caveats, though, the fact is that we do have reason for optimism about UK equities – albeit one that only exists thanks to the market’s tendency to over-react.