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Buttonwood: What goes up

via The Economist: Finance and economics on 7/1/10

Buttonwood

What goes up

Equities are still suffering from a valuation hangover

Jul 1st 2010

THE best bet for the long term is to buy shares and hold on to them. That was the lesson hammered into the heads of investors in the 1990s when the "cult of the equity" was at its peak. Unfortunately, they absorbed the message at precisely the wrong time.

The past decade has been disastrous for equities. Over the ten years to June 18th 2010 investors in developed-market equities earned a cumulative total return of minus 7.9%. By contrast medium-dated Treasury bonds returned 95.3% and high-yield American bonds 102.2%. Richard Cookson, the chief investment officer at Citi Private Bank (and a former journalist at The Economist), points out that the cumulative outperformance of high-yield bonds over equities dates back to 1995.

At first glance this seems rather odd. Bondholders have first claim on the corporate sector's cashflow and shareholders take what is left. In theory, shareholders should earn the best returns over the long term provided profits keep growing. After slumping in 2008 profits have recently rebounded and, in the case of America, are close to a post-war high as a proportion of GDP. Even if profits had been terrible, owners of high-yield bonds would have suffered too because of a likely jump in corporate defaults.

The answer to the conundrum is valuation. As the cult of equity gained more and more adherents in the 1990s share prices were bid to stratospheric levels. On the best long-term measure, Robert Shiller's cyclically adjusted price-earnings ratio (which averages profits over ten years), valuations in 1999 were more than a third higher than their previous peak, just before the great crash of 1929. It was a nice irony. Investors bought shares because they desired high returns but their enthusiasm pushed prices to a level from which high returns became impossible.

Exactly the same thing happened in the American housing market. A naive belief that house prices could never fall at the national level encouraged excessive speculation and lax lending, thereby precipitating an eventual collapse.

It is tempting to assume that because equities have performed so badly over the past decade, they must be a sure thing to perform well over the next ten years. But that argument failed in Japan. By the time the market there peaked in the late 1980s, historic price-earnings ratios were in the 50-100 range. Western valuation measures, sceptics were told, were irrelevant in the Tokyo market. The result of that bubble was a bear market that is already into its third decade.

Wall Street never quite matched Tokyo's valuation excesses. Nevertheless, although the cyclically adjusted ratio has fallen from a heady 44 in 1999, it is still around 20, a level well above the historical average of 15. So future returns are likely to be lower than the previous norm.

A higher-than-average valuation implies that investors expect better-than-average profits growth. But this week's equity-market wobbles illustrate that investors are unconvinced that the global economy can manage a V-shaped recovery, especially now that fiscal stimulus is being withdrawn in Europe and elsewhere. The commitment to continued monetary stimulus, in the form of near-zero interest rates, is a double-edged sword. It may drive investors out of cash in search of higher returns but it also indicates how anxious central banks continue to be about the economic outlook.

Despite these worries, there may still be some segments of the stockmarket that perform well. According to Dhaval Joshi of RAB Capital, pharmaceutical firms' dividends have grown at an average of 12% a year over the past 40 years, five percentage points above general dividend growth rates and eight percentage points above inflation. Total dividend income from the industry has fallen very rarely, even in recessions. That remarkable performance reflects a rising share of health-care spending within GDP, particularly in America, where a wealthier and greying population places a high value on access to health care.

Pharmaceutical shares have underperformed the global market this year. The industry's giants trade on a discounted price-earnings multiple, reflecting fears that the days of blockbuster drugs are over. Globally the sector yields 3%, higher than the yield on inflation-linked Treasury bonds, despite its history of offering real income growth. Reliable sources of dividend income are becoming scarce (shareholders were let down first by the banks, then by BP). So it is surprising that pharmaceutical stocks are so little cherished.

Economist.com/blogs/buttonwood

Finance and Economics