The long, slow road to recovery

Anthony Hilton
17 Feb 2009

Every year, three senior academics at the London Business School, Elroy Dimson, Paul Marsh and Mike Staunton, produce an analysis of long-term investment trends covering the world's major stock markets. It was sponsored by ABN Amro but has proved more resilient than the bank, and now comes courtesy of Credit Suisse.

There is nothing quite like it because, while its unrivalled long-term statistics make the case for equity investment in comparison to the returns from other asset classes, the analysis also makes clear just how uncertain equity returns are and how difficult it is to capture them. Indeed, anyone thinking of investing in shares for the first time should read this book before they buy. They may feel the need to lie down, during which time the desire will go away.

In a wealth of data this year, two things seem particularly pertinent. One is their challenge to the belief that if shares have plunged to lows, and if the world is not coming to an end, all one needs to do is buy good companies now and sit tight. That seems to be broadly what Warren Buffett has done over the years, and he is unchallenged as the world's most successful investor. So might it not work for others?

The academics' answer is it might, but don't count on it. They looked at all sorts of markets - some high, some middling, some low - and then examined how they performed in subsequent years. For the theory to hold, one would expect shares coming off a low base to do better than those where there had been no heavy prior falls. But it did not work like that. There was no discernible pattern, no statistical support for the theory over any reasonable time horizon. Cheap shares can stay cheap for a very long time.

Just how long is also startling and, it must be said, depressing. The FTSE 100 index hit its all-time high of 6930 on the last day of 1999. The academics calculate that the index has just a one-in-two chance of hitting a new high by 2019, some 10 years hence.

Even if the index is calculated with all dividend income reinvested, which has the effect of increasing its value, there is still only a 50-50 chance it will reach new high ground by 2014. Of course, for individuals this latter calculation does not work because tax and charges make it impossible to reinvest all the dividend income.

What this means is that if someone was sucked into the stock market at the time of the tech bubble around the millennium, they have only a 50-50 chance of getting their money back inside 20 years. But we should not actually be surprised by this. It was 1949 before American shares got back to their 1929 levels, while in Japan shares have not even got halfway back to the peak they hit in 1989. That is rather at odds with the typical advertisement from the fund management industry, however.

Another great insight delivered by the long-run analysis is the way it splits up time periods into golden ages for equity investment and the corresponding bear markets, which are real horror shows. However, in the past 100 years there have been only four really bad periods, during which world stock markets fell by almost 50% from peak to trough. The First and Second World Wars were not among them. Rather, they were 1929-31, then the first oil shock of 1973-74, followed by the tech crash of 2000-2 and finally the current credit crash, which started in 2007.

Think about this for a moment, and understand why the world's pension funds are in trouble. Two of the worst stock-market crashes in a century have taken place in the past decade.

The academics don't try to explain this, but how's this for a theory? The oil-price shock was the exception because the overnight quadrupling of the crude price created a massive cost shock that would have destabilised anything.

But the other three have common roots. The 1929 crash, the tech boom and bust and today's crisis all came after periods of very easy credit during which money was dirt cheap and easily available. This wall of cash gave a supercharged banking sector the opportunity to go on a speculative binge, and to take its favoured clients with it.

This it did partly through proprietary trading, which is where it plays the markets for its own account, partly by pumping debt into everything that moved to jack up the investment returns - albeit at much higher risk and by intimidating the corporate sector, under pain of takeover, to take the same highly leveraged path.

The result was an explosion in asset prices, most typically in property and shares but overflowing into all other asset classes from fine art to fine claret. None of this was caused by genuine wealth creation. It was caused by hyperactive bankers pumping more and more money into a fixed supply of assets until, like a balloon, it burst.

Meanwhile, bankers insist that they really need massive bonuses so they can attract talent and go back to their old ways. On this analysis, I am not sure I want them to.