For Market Gains, Investors Should Learn From Past

Philip Coggan is the Buttonwood columnist and capital markets editor for The Economist.

Buy stocks for the long term, and you will prosper. But when investors think about the next 40 years, they should consider the lessons of the last 40. It makes an enormous difference when they started to save.

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The right time to start saving was in 1982. Bond yields were close to their all-time peak and the Dow Jones Industrial Average was around 1,000, a level it had flirted with in 1965.

The developed world economy was about to enter the “great moderation”, a lengthy period during which inflation fell and recessions were rare. You did not have to be a genius to make money, although many who prospered were awarded that title.

The wrong time to start saving was in 2000. Equities have underperformed government bonds since that date, while central banks have slashed the returns on cash. Workers retiring in 2012 after 30 years of saving will likely have a much smaller pension than those who retired in 1999.

In short, the market goes through long cycles as it moves from undervaluation to overvaluation and back again. Alas, we cannot be sure when the peaks and troughs in those cycles will occur. But we can learn a few lessons from history. It is fairly obvious that the likely future returns for government bond investors fall in line with yields. Some might argue that the key factor is real (after inflation ) rather than nominal yields but in current circumstances, there is no difference; both are very low. Bonds have enjoyed a 30-year bull market and the cycle seems certain to turn (and may have turned already; the low for 10-year Treasuries was 1.72%, back in September).

For equities, there are a number of potential valuation methods but two (the cyclically-adjusted price-earnings ratio and the Q ratio of share prices to the replacement cost of net assets) show a clear peak in 2000. We have clearly been in the down phase of the cycle since then. Even so, this still does not look like a particularly advantageous moment to start saving. Global equities have returned 5.4% per cent per annum in real terms since 1900, according to the London Business School. Of that return, 4.1 points has come from the dividend yield. But the global yield today is just 2.7%, indicating (as with bonds) that returns are likely to be lower than average.

Even if equities look a better bet than bonds, there is no guarantee that the boom conditions of the 1980s and 1990s will return. Indeed, equity markets can be depressed for quite long periods; the Tokyo stock market is still 75% below its peak in 1989, another moment when valuations reached stratospheric levels.

But the good news is that an investor who plans to retire in 2050 can afford to be patient. There will surely be some point at which equity valuations can reach levels from which they can only rise as they did in 1932 and 1982. The trick will lie in being able to recognise that point when (most likely) all other investors are in a state of despair.

Philip Coggan is the Buttonwood columnist and capital markets editor for The Economist.