Investors should expand horizons

If there is one weakness of investors, it is the extrapolation of recent equity market returns into future returns. When planning retirement, this can be financially fatal. While predicting short-to-medium term moves in stock markets is fraught with danger, when one takes a step back and analyses the situation, there are a few good indicators of what expected returns on stock markets may be.

Clearly the starting point is crucial in investment decisions. In theory, if you time your investments well, then you can achieve good returns. In practice, timing the market is nigh on impossible. There is good news for long-term investors, however. Time is a great healer.

Jeremy Siegel (in Stocks for the Long Run) analysed 200 years of US stock market returns and showed that once your time horizon extends beyond 10 years, then holding stocks is superior to holding bonds to T-bills not only on an average basis, but also taking into account the extremes in performance.

For instance, on a 10-year time horizon, the worst and best real annualised stock market returns were -4.1 per cent and +16.9 per cent, respectively. For bonds, the corresponding numbers were -5.4 per cent and +12.4 per cent. Once you move out to 20 years, the worst case was +1.0 per cent.

While the long-term benefit of holding equities is clear, it says nothing about potential returns at current levels. One study of S&P 500 real returns, using a mere 135 years of data, has shown they vary significantly depending on what the price-earnings (PE) ratio was at the time the investment was made.

For instance, if the PE ratio was 12, then the return was 8.1 per cent, while a PE ratio of 15 generated real returns of 6.1 per cent.

In terms of variability of returns, if you bought the S&P 500 with a PE ratio of less than 12, then real returns were always positive. However, once PEs moved above this level then the worst outcomes were between -2.6 per cent and -4.6 per cent on an annualised basis.

For those looking for double-digit returns from here, the above does not make pleasant reading. The above analysis suggests that with the S&P 500 trading at a PE of 18, then five per cent real returns annual average over the next 10 years are probably more realistic (historical range for such returns from this PE starting point has been -2.6 per cent to +12.2 per cent).

Against this backdrop, the search for cheap markets has intensified as risk appetite has soared, pushing valuations higher across asset classes. The good news is that there are still some of the markets that are reasonably valued and have good prospects for private sector growth.

Unsurprisingly, these markets are ones that are not highly correlated with global stock markets and have experienced serious weakness in recent times - namely the Gulf markets. Therefore, we may have to look less further afield to locate reasonable valuations than many investors around the globe.

- The writer is the Regional Head of Research for the Middle East and South Asia at Standard Chartered Bank. The views expressed are his own and do not necessarily reflect the views of the bank.