Salient to Investors:

Elroy Dimson, Paul Marsh  at London Business School and Mike Staunton at London Share Price Database write:

A decade is too short to judge stock returns.

The last decade has been the lost decade. Since 2000, the MSCI World index has lost a third of its value in real terms, while the major markets all gave negative real returns of an annualized -4 per cent to -6 per cent.

The 1990s was a golden age as inflation fell from the high levels of the 1970s and late 1980s, lowering interest rates and bond yields, and expected profits growth accelerated leading to strong performance from equities (except in Japan), bonds and T-bills.

$1 invested in US equities in 1900 with dividends reinvested grew at an annualized rate of 9.2 percent per year to $14,276 by the end of 2008, versus an almost 25-fold increase in consumer prices. $1 invested in equities in 1900 showed annualized real returns of 6%, or purchasing power by 582 times, versus 2.1% in bonds, or 9.9 times, and 1% in T-bills, or 2.9 times.

The two world wars were less damaging to world equities – real returns of -18 per cent and -12 per cent – than the peacetime bear markets – real returns of -44 per cent to -54 per cent.

The worst bear market was 1929 to 1931 – the world index fell by 54 per cent in real US dollar terms – followed by the current crash at -53 per cent.  The 21st century has hosted 2 of the 4 worst bear markets in history.

The four “golden ages” were the 1990s when the world index showed a real return of 113 per cent, the 1980s with a 255 per cent real return, the decade after WWI with a 206 per cent real return, and from 1949 to 1959 with a return of 516 per cent.

Using the US experience could give a misleading impression of equity returns elsewhere or of future equity returns for the USA itself because of “success” bias – since 1900 the US rapidly became the world’s foremost political, military, and economic power.

Over the last 109 years, the real equity return was positive in every location, typically at 3 to 6 per cent, and equities were the best performing asset class everywhere. Bonds beat bills everywhere except Germany.

In most countries bonds gave a positive real return, but 5 countries experienced negative returns and were also among the worst equity performers – their poor performance dates back to the first half of the 20th century, and were the countries that suffered most from the ravages of war and civil strife, and from periods of high or hyperinflation, typically associated with wars and their aftermath.

The US was not the top performer, nor were its returns especially high relative to the world averages. Many of the best performing equity markets over the last 109 years tended to be resource-rich and, quite often, New World countries.

Over the long run, investment in equities has been accompanied by significant volatility.

Treasury bills are preferred over long-term government bonds as the risk-free benchmark because bonds are subject to uncertainty about future inflation and real interest rates.

The annualized premium, relative to bills from 1900 to 2008, was 5% for the US, 3.7% for the world ex-US and 4.2% for the world:  relative to bonds was 3.8% for the US and 3.4% for the world.

Over a single year, equities are so volatile that most of an investor’s return comes from capital gains or losses, with dividends adding a relatively modest amount, but the longer the investment horizon, the more important is dividend income. For the seriously long-term investor, the value of a portfolio corresponds closely to the present value of dividends, while the present value of the eventual capital appreciation dwindles greatly in significance.

Real US dividends grew at an annualized rate of just 1.2 per cent, while most countries recorded less than 1 per cent. Dividends and probably earnings have barely outpaced inflation. Over the last 109 years, the price/dividend ratio of the world index grew by just 0.36 per cent per year.

The annualized historical risk premium relative to bills on a globally diversified equity portfolio was 4.2 per cent, comprising 3.2 per cent for the amount by which annual dividends exceeded the real risk free rate, 0.65 per cent per year from real dividend growth, and 0.36 per cent per year from an increase in the price to dividend ratio.

Dividend growth turned out to be higher than expected. From 1900 to 1949, the annualized real return on the world equity index was 3.5 per cent. From 1950 to 1999 the annualized real return was 9 per cent.

The 4.2 per cent per year historical equity premium on the world index exceeded expectations, and was higher than the premium investors required in advance. Adjusting for non-repeatable factors, we infer that investors expect an annualized equity premium relative to bills of 3 to 3.5 per cent, below the long run historical premium and well below the premium in the second half of the 20th century.

Investors should not expect an immediate return to either previous market levels or previous high rates of return as markets will take a long time to recover from the battering they have received during the credit and banking crisis. We were spoiled by the high returns of the 1980s and 1990s.

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