The markets are close to record highs, but they’re still the best long-term bet

With stock markets close to record highs, should we be running for cover? Ahmad Awawi, CC BY-SA

The FTSE 100 reached 6877.39 points last week. It was the highest since its all-time peak of 6950.60 on December 30 1999 before the start of the deflation of the great dotcom bubble in January 2000. It is currently trading about 50 points lower, but many analysts believe it will break 7000 before the end of the year. What does this mean for stock market investors, if anything?

To put this into perspective we have to remember that the stock market is the best asset class for investors with very long time horizons. To see this, suppose that for every year over the next 40 years you put £2500 into just one of the following asset classes:

(i) Gold (ii) Property (iii) The stock market

Based on the historical record of over 200 years, how much can you expect to have at the end of 40 years, after adjusting for the loss in value due to inflation?

The answers are surprising. Over the 40-year period you have invested a total of £100,000. The expected value of your £100,000 investment at the end of 40 years is:

(i) Gold: £100,000

(ii) Property: £240,000

(iii) The stock market: £500,000

All of these figures are adjusted so that they are not distorted by inflation. What they show is that over the very long term, gold holds its value but doesn’t add anything.

The same is also true of property. The extra £140,000 comes from 40 years of reinvested rental income. The stock market is different. Over the very long term, it outperforms every other major asset class.

Dark side of the boon

These conclusions about investment performance are based not merely on the historical record but are predicted by standard financial theory. The stock market is the only major asset class that allows us to invest directly in human capital. A block of gold or a block of flats cannot write The Dark Side of the Moon, invent the iPhone, television, motor cars, debit cards, ice cream or anything else.

In a mixed economy, value is created (and sometimes destroyed) by both the private and public sectors. In the private sector, value is created by businesses creating new products and services whose value is greater than the costs of creating them.

The simplest and most direct way of investing in this value creation is to buy shares in companies listed in the stock market. When a company creates value, the price of its shares goes up. After 40 years, the value of your shares will reflect 40 years of value creation by the companies you invest in.

So what meaning can we attach to the fact that stock markets in the UK and around the world are now approaching or exceeding their historic highs?

In actual fact, it is not really true. After adjusting for inflation, the UK and US stock markets are respectively about 25% and 5% below their dotcom peaks. The salient fact here is not that stock markets are high, but that they are only now approaching the levels achieved 14 years ago.

Stock markets move in slow cycles, with long bull markets and long periods, up to even 20 years, where they go nowhere. As predicted by behavioural finance, stock market bubbles are followed by extended periods when the market deflates to, or even falls below, fair value.

The long retrenchment

In the great dotcom bubble we witnessed the greatest ever stock market over-valuation in recorded history. An extended period of miserable returns is exactly what was predicted by behavioural finance theorists back in 2000.

On long-term measures of value, the UK stock market is now at fair value or even below fair value. One way of showing this is to look at the long-term average for the UK ratio of stock market prices against the listed companies’ earnings (P/E). It is around 12 to 15, depending on which measure you use, while for the FTSE 100 it is currently around 13.

The long-term dividend yield (how much a company pays out in dividends each year relative to its share price) is around 4% and for the FTSE 100 it is now just below 4%. Looked at as a whole, over the next 10 years we can expect the FTSE 100 to deliver good investment returns that are in line with its long-term average.

But even a 10-year investment horizon is somewhat speculative when it comes to the stock market. Paradoxically, the stock market becomes more predictable the longer into the future that we look. While good returns over the next 10 years appear to be quite likely, excellent returns over the next 40 years appear to be a virtual certainty.