October 31, 2016: Economy Power And Long Term Stock Returns

Nov 1, 2016 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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Economy Power And Long Term Stock Returns 

The recent US presidential election is coming to its final days. However, its unusual bitterness and sharp divisiveness among voters have been very discouraging. Many are disappointed by the slow economy growth. Some even hold that the US economy power has declined and the country is on the verge of losing its dominant number one position in the world, economically or politically. 

Naturally, investors are concerned about their investment returns, especially in such a depressing state (certainly, this is a subjective view). However, putting the economic, political and even military issues aside, if investors look at the investment history, things are much brighter in a long term. 

Long term UK stock returns

The United Kingdom was the number one economic power house in the world before World War I. It gradually lost the title to the US in the two world war periods. By the end of World War II, the US emerged solidly as the number one economy power house in the world. Many investors would expect that in the past 50 or 100 years, the US equity returns would be higher (or much higher) than that in UK, given the common sense of winners and losers. Well, in this case, they are wrong.

The following data are taken from Barclays annual UK Equity Gilt Study 2016 that was published in March 2016. 

UK Asset Class Real Returns

 

US Asset Class Real Returns

Real investment returns are the extra returns over inflation. Though UK equities had a lower returns in the past 20 and 10 years, they actually had a better returns in the past 50 years, compared with the US. The following chart shows the returns for each decade: 

In fact, since World War II, UK equities had better returns from 1965 to 1985. In essence, it’s hard to argue that their returns are worse than the US’s even after it ‘declined’ and ceded its number position to the US. 

Risk premium in a fair capital market

Though one can offer many reasons why this is the case, we have maintained that equity investments should command a risk premium over cash and even safer investments such as bonds. What that means is that regardless of the macro economic situation, company stocks should give investors (their owners) a better return. since a company owner would demand higher returns compared with just simply putting money into a bank: otherwise, the owner would just simply closes the company and get similar or better returns in a bank without much risk and work, for example. In aggregate, equities in general should return more than cash or even safer fixed income. 

The other important factor is that a stock market index automatically functions as a filter to eliminate bad companies that are losing money or have little profit. For example, the famed S&P 500 index has strict criteria to select companies to be included in the index. Even the broad stock market acts as the first line of filtering: companies that have lost a great deal of business and money will be delisted off the exchanges. 

Of course, the above assertions hinge on a fair capital market with less manipulation. The same argument for positive long term stock returns does not apply to those countries that are corrupted or have a manipulated market. 

Even though the US economy and its political system are now facing difficulties, we are still optimistic on their long term future. This is because a democratic system like the one in the US, though not optimal or not without drawbacks, can correct itself in a long period of time. Furthermore, the US companies are still some of the most competitive in the world. Even if the US presidential election may result in a set back to their business, we view this as a short term issue. Finally, the history of UK equity returns can only give us even stronger conviction on the positive long term stock returns. 

Market Overview

The good news in Q3 earnings continues: as of last Friday, Factset reports that the blended (combined with 58% already reported and 42% expected) earnings growth rate for the S&P 500 is 1.6%, compared with the expected -2.2% year over year decline. If the trend holds, that would mark the first positive earnings growth since 2015. Furthermore, the blended revenue growth rate for Q3 2016 is 2.7%. We view this is significant as we are always skeptical on earnings that can be financial engineered. For revenues, the numbers are better harder to fudge or they are much cleaner. 

On the other hand, stocks have been volatile. The chaos in the presidential election only makes this worse. Furthermore, high yield bonds have started to experience a noticeable outflow and weakness, ditto other rate sensitive assets including REITs. The worst scenario would be a rising inflation environment with an anemic economy growth (the so called stagflation). This would force the Federal Reserve to raise interest rate, only to jeopardize the already weak recovery. In terms of investments, this would be bad for both stocks and bonds. 

As always, we will stay on course and respond based on our strategies. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

The current nasty presidential election is a reflection to the long standing reality facing Americans and others: since the financial crisis in 2008-2009, not much substantial structural change in the U.S., European and emerging market economies has taken place. Economies have heavily relied on low interest debts. Capital might be misallocated to unproductive investments and consumption. In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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