Choose equity if you live long

This is an article from FT. 


A hedgehopper's guide to living with inflation

Keynes' legacy is up for debate these days but there is almost universal sympathy for his scornful views of the long run. His dictums that in the long run we are all dead, and that the market can stay irrational longer than you can stay solvent, are unarguably true.

For those young enough, there is safety in the very long term. But those too old to wait around need help to hedge against the risk that things go wrong in the short run.

Here, miming the long-run data can still help. This week saw the publication of two annual monumental studies of long-term securities returns: the Barclays Equity Gilts Study and the Credit Suisse Global Investment Returns Yearbook. Both go back more than a century and cover many countries.

Mining such data can help us to deal with short-run risks and both surveys this year attempted to do so. On balance, their findings are still somewhat depressing but the condensed wisdom of a century is still useful.

First, equities do outperform in the long run term but that long term can indeed be very long. In the US, since 1900, the longest anyone has had to wait to derive a positive real turn from stock is 17 years (manageable for most of us); but, in Italy, that figure is 74 years. 

How should those with time to wait best harness this insight? The Credit Suisse data confirm that stocks outperform if they are smaller (US micro-cap companies have grown at 12.6 per cent a year since 1926, compared with 12 per cent for small-capitalisation companies and 9.5 per cent for larger companies); if they are cheaper (higher dividend yield stock have risen at 10.9 per cent a year in the UK since 1900, compared with 7.7 per cent for low yielders); and if they have momentum at their back. Stocks that are rising tend to keep rising, and laggards tend to keep lagging. Place trades that take advantage of these inefficiencies and you will be rewarded in the long run.

What about those who cannot wait? The bad news from the Barclays survey is that safety has never been so expensive. Long-term interest rates on US sovereign debt are not unprecedentedly low. The forwards market, which institutions use to lock in interest rates for the future, shows that markets expect 10-year bond yields to average almost exactly 1 per cent from 2022 to 2032. Only 30 years ago, these bonds yields as much as 15 per cent.

Plainly, the intervention by central banks to push down yields by buying bonds has much to do with this. But the Federal Reserve is promising to keep rates low until 2014; that cannot explain such confidence they will stay low from 2022 to 2032. Barclays suggests the main explanation is shortage of supply. Since the financial crisis struck, several assets have been struck off the list of "safe" assets, such as US mortgage agency debt, structured credit, and Spanish and Italian bonds. For those safe assets that remain, this pushes up the price, while pushing down the yield.

Bonds are historically expensive relative to stocks. But if this is because of a permanent constriction  in the supply of safe assets, these is no particular reason to expect this to change; and, therefor, sadly, it does not imply that stocks are particularly cheap.

Bonds' coupons are fixed over time, so a low long-term bond yield usually implies confidence that inflation will not rise and eat into their purchasing power. But in these circumstances, low bond yields do not imply any great market belief that inflation is under control.

Indeed, of course, there is great fear of inflation. What can act as a hedge? These days, inflaiton-linked bonds are available. They are extremely expensive, offering a negative yields, but they will rise with inflation as long as the issuing government avoids default.

The Credit Suisse survey looked at other possible inflation hedges. The results, shown in the chart, are discouraging. Equities are badly affected by bouts of inflation but do at least outperform bonds. Housing is much less affected. Gold is as close to an inflation hedge as the authors find out even here gold's performance in the long term is erratic. As its real (inflation-adjusted) price has differed substantially over time, it cannot be regarded as a good hedge.

For the short term, then, the long term has depressingly little encouragement. Safety is in short supply and expensive; stocks are not as cheap as they look and hedging against the risk of resurgent inflation in the future is very difficult.

It is best, for those who can, to hunker down in well-chosen equities for the longer term. For those who cannot, diversify as much as possible. from FT