In the long term, share markets always go up. At least that is what we are told by the investment industry.
A random google search on the topic uncovered an article written in June 2013 by a Private Client Adviser with a major financial planning firm:
‘If you had invested $100,000 in the ASX200 back in 1980 and reinvested your dividends back into additional shares, you would have over $4million today, which includes the recent short-term impact of the GFC! This equates to an average annual return of around 12% per annum. And the average annual return of the stock market from 1900 to today has been around 13.50% per annum.’
On face value, the writer puts forward a convincing argument for the wealth creation powers of the share market.
To be fair to the writer, they are not on their lonesome in putting forward these statistics. The industry quotes this stuff ad nauseum to support the ‘shares go up in the long term’ mantra.
However, if we apply a modest amount of critical thinking to the statement, the argument is not quite as convincing.
Firstly, the industry invariably starts its compound calculations in 1980. Why that date? That’s just before the start of the greatest bull market in history. In January 1980 the All Ords index was 480 points.
In January 1970, the All Ords was 430 points. A rise of only 50 points (12%) in a decade. Better airbrush that period out of the data.
The writer’s assertion that the return between 1980 and June 2013 ‘equates to an average annual return of around 12% per annum,’ is correct.
However this period also witnessed the rapid growth in global private debt levels.
Australia was not backward in coming forward either in regards to the global debt party.
Household debt has risen five-fold since 1980 — from 20% of GDP to around 100%.
Source: Macro Business
Australia’s GDP in 1980 was $150 billion. At 20% household debt was $30 billion.
Today our GDP is $1.1 trillion.
In dollar terms, our household debt has grown from $30 billion to $1.1 trillion — a 3700% increase over the past 34 years.
Do you think all this extra money floating around in the system might have had some influence on corporate earnings, which in turn helped boost share prices? You bet it did.
That’s the past. What we’re concerned about is the future. Therefore if rising debt levels contributed to rising share prices, we have to make a judgement call on where household debt levels are going to in the coming decades.
Will debt levels rise by another 3700% over the next 34 years? Maybe, but I wouldn’t bet on it.
The GFC was a warning about having too much debt in the system. That warning has largely been ignored. Therefore, the system has another too-big-to-ignore warning lying in wait for us. The higher probability in the coming decades is that debt levels (as a percentage of GDP) will stagnate or fall.
The other fact that is ignored in the 12% per annum declaration is the price/earnings expansion over this period.
The reason this crucial piece of information is ignored is because the industry is ignorant to the impact of PE expansion and contraction on share valuations. In all my years in the investment industry, not once was it ever mentioned.
In 1980, the All Ords was trading on a P/E of six times. Today it is around 15 times.
Grab a compound calculator and check this for yourself.
A company earning $1 million times P/E of 6 equals $6 million
A company earning $1 million times P/E of 15 equals $15 million
The rate of compound growth (from $6 million to $15 million) over a 33 year period equals 3% per annum.
Without P/E expansion, the annual average return would have been 9% per annum.
OK, that too is the past. If the future is going to replicate the past, then over the next 34 years the
market P/E ratio must expand from 15 times to 38 times.
Again, what are the chances of that happening? Highly unlikely. And if it does, it will be completely unsustainable.
When we put the two factors together — debt levels expanding by another 3700% and the All Ords P/E ratio going to 38 times — what do you reckon about the future being a repeat of the past?
Would you bet your retirement on that outcome? Personally, I wouldn’t.
The two more likely scenarios:
a) Stagnating debt levels and a flatlining P/E ratio
b) Shrinking debt levels and a contracting P/E ratio
Either of these outcomes would adversely impact the ability of the share market to deliver anywhere near double digits returns.
The last sentence in the statement, ‘And the average annual return of the stock market from 1900 to today has been around 13.50% per annum’is completely incorrect.
In January 1900, the All Ords was nine points. At the time the statement was made, in June 2013, the All Ords was 4760 points.
This equates to an annual compound return of 5.75%. Throw in (say) 4.5% in dividends and the market delivered around 10.25% per annum.
That 3.25% overstatement compounds out to huge error over a 113 year period.
$1,000 invested in 1900 at 10.25% per annum, would grow to $61 million. $1,000 invested in 1900 at 13.5% per annum, would be $1.6 billion.
Slightly more than a rounding error.
When you delve into the numbers, you see the industry’s case of ‘shares for longer and stronger’ is not quite the open and shut case they would have you believe.
But let’s face it, how many people really peel back a layer or two to check the veracity of the claims? Very few.
And that’s the way the investment industry prefers it.
If they didn’t have the superior performance of the share market to sell, what else would they have? Not a lot.
So they flog that one-trick pony for all its worth…hoping no-one really asks too many hard questions.
Here’s some real facts to ponder.
These are dates the following major indices first reached the level they are currently trading at:
- All Ords — March 2006
- Stoxx 50 (Europe’s leading blue chip index) — August 2005
- Japan’s Nikkei 225 — July 1986
- Shanghai Composite — March 2007
Long term European investors have had no growth for a decade. That is not much fun if you were a 65 year old retiree in 2005.
Over the very long term the share market has delivered extended periods of exceptional performance. But there have also been times when it’s been the worst place on earth to have your money. If you are retiring or retired you do not want to be caught in one of these periods.
Twisting the data to say otherwise is misleading and self-serving.
In my opinion we are on the cusp of markets entering a prolonged period of squaring up the ledger — expansion followed by contraction.
If you are retired or close to retirement look very, very closely at the growth numbers your financial planner puts into their computer models. My guess is they will be way too optimistic.
You cannot afford to get this wrong. Time will not heal the wounds inflicted on your portfolio by a serious market downturn.
Editor, The Daily Reckoning
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