Return of the “cult of equities”?

Developed market equities have performed strongly over the past 10 years, the past five years and, despite their monumental sell-off in the first quarter of last year, in 2020. Asset owners learned a hard lesson in 2008/09 about risk management, but are now wondering: is this the new normal for equities, should they increase their equity allocation, and is diversification still worth it?

Hindsight is a virtue and investors should be wary of chasing yesterday’s returns. In this blog, I’ll analyse the drivers of equities’ recent performance and dare to give some long-term forecasts.

A global perspective

Despite the narrative of strong equity returns everywhere, a huge performance differential has opened up between regions. Over the past 10 years we certainly had strong returns in North America (+228%), but there isn’t much of a “performance miracle” elsewhere. Europe (+80%), the UK (+35%) and Japan (+88%) show returns largely in line with our long-term equity return assumptions.

A deep dive into North America

So what has been driving the stellar US equity performance? Dividends generated a meagre c.1.7% p.a. Capital gains dominated, with 11.0% p.a., and can be split into an earnings (EPS growth was 3.9% p.a.) and a valuation effect (a rerating of equities/equities becoming more expensive). The price-earnings ratio grew from 15.6 to 30 through this period, delivering returns of 6.8% p.a.

I’ll add two adjustments to the data. First, 2020 earnings were depressed by the virus. Trend EPS growth was around 5.3% p.a. and valuation effects were 5.7% p.a. Trend earnings imply a lower P/E ratio of around 28. Second, share repurchases are tax-favoured versus dividends and are very popular in the US. Net share repurchases were around 2.0% p.a. over the 10-year period. Total cash distributions to investors (dividends plus repurchases) were thus a healthy 3.7% p.a. As these repurchases reduce outstanding shares, they create an illusion of earnings growth: growth in smoothed EPS (excluding repurchases) was 3.3% p.a.

Lastly, I need to discuss the elephant in the room. US equities became more expensive – without these valuation effects, their total return over 10 years shrinks from 228% (12.6% p.a.) down to just 71% (5.5% p.a.).

The structural decline of interest rates explains almost all of this valuation effect: interest rates matter for equity valuations as investors compare the prospective returns of equities to bonds and derive a fair value by discounting dividends or earnings. As a basic model, I really like the Gordon growth model (see the chart above). It suggests that a decline of US yields from over 3% to 1% expands the “fair” P/E ratio from 15 to 25, thus adding 5.1% p.a. to the 10-year return.

The outlook

Equities have had a great run. But returns were boosted by equities getting more expensive, and these valuation effects probably can’t be repeated. In fact, rising yields may now be a risk for equity markets worth monitoring.

A sustainable return forecast needs to rely on current distributions (dividends and net repurchases) and their future growth. As cash distributions grew faster than earnings and with the payout ratio over 80%, further upside depends on earnings growth.

Over the very long term, corporate earnings grow in line with GDP, but some of that growth is due to new and unlisted companies. Existing investors are diluted and miss out on some of that growth. That wasn’t the case over the past 10 years as overall earnings grew pretty much in lock-step with GDP. The lack of a strong recession helped and much has been written about the huge profits that a handful of tech companies managed to reap over that period. My assessment is that the recent trend of cash distributions and EPS growth (3.3+3.7=7.0% p.a.) was lucky and is unlikely to continue.

Equity investors should be aware of what they are signing up for. In a low-return environment with bond yields of 1%, even a 5% target return might well be attractive. But there is no reason to believe that recent bumper returns will continue or that giving up on diversification is good investment advice.

Appendix: performance of indices cited