Brent Sheather: Running hard just to keep up

A few months back we looked at a research paper by two Deutsche Bank analysts which showed that many investors base their buying behaviour on the assumption that historic returns will continue.

The Deutsche Bank analysis suggested that many international bond and sharemarkets were overvalued and would struggle to repeat historic returns.

Today, international bonds and shares boast a 12-month return in kiwi dollars of 30.2 per cent and 9.4 per cent respectively. The cheerleaders of international investing - fund managers and financial advisers - are slapping each other on the back and telling anyone who will listen: "I told you so."

So, 30 per cent and 9 per cent respectively later, is now really a safe time for mum and dad to invest some of their savings in international bond and sharemarkets?

Tim Bond, an investment strategist with institutional bank Barclays Capital, in London, isn't convinced.

Each year, he helps write the Barclays Equity Gilt Study and, in the 50th issue, he sets out a simple method for forecasting bond and sharemarket returns. At the same time, he shows that contrary to the warning from the regulatory bodies, past returns are indeed often indicative of future returns, just in the opposite direction.

But first to the forecasts. Bond notes that with fixed interest investments the future return is highly correlated with the yield at which we buy the bond.

The most simple example is a one-year bank deposit - if the interest rate is 7 per cent you get that return and your money back. No rocket science there. But what really counts is the real, after-inflation return. Getting 15 per cent a year isn't all that flash if inflation is running at 28 per cent.

When we buy a bond or invest in a term deposit we know what the income will be but we don't know what inflation will be. This is particularly significant for long bonds of 10, 20 or 30-year durations.

Bond reckons that, based on historic data, investors buying long-term UK government bonds at the current yields of around 3.9 per cent should expect an average real, after-inflation return of negative 0.3 per cent a year over the next 15 years.

Using 105 years of historic data, he shows that government stock interest rates below 4.3 per cent imply negative real returns over the next 15 years. While New Zealand's government stock rates at 5.8 per cent are higher than those in the UK, our inflation has been higher, on average, too.

Bond reckons UK and US bonds are overpriced and that shares are a better bet, but only just, and future returns will be nowhere near as good as they have been in the past.

In the same way that interest yields on bonds signal returns so they also affect the return on shares but to a lesser extent given the more modest contribution of income to equity returns.

Furthermore, Bond observes that share valuations (PE multiples) are not random - they exhibit swings from strength to weaknesses. Thus, the overall average long-run return from equities is not a good guide to future long-run returns.

This is particularly significant because much of the promotion of the benefits of owning international shares rides on the fact that past performance has been great.

But what Bond says is that the better it has been in the past, the worse it will be in the future. Rather, over the time horizons that matter to long-term investors, past returns are negatively correlated with future returns.

In practical terms, this means that the average returns experienced over the past 15 years will be negatively correlated with the probable returns we will experience over the next 15 years.

The best explanation for periods of high returns is that they tend to involve the market trading at higher valuations - the sharemarket values individual companies at higher price-earnings ratios.

Bond tests his theory and finds that, as with bonds, long-term returns from shares are correlated with the yield at which they are purchased.

Bond concludes as did Cliff Asness (Herald July/August 2005) that bonds and shares aren't always a sure bet but, as common sense would confirm, it all depends on the price you pay.

At present prices, US stocks look likely to produce long-term returns of 7 per cent a year or so, not as good as the long-term record but about 3 per cent a year better than long bonds.

And remember shares are serially, negatively correlated with long-term returns: after a period of strong returns what goes up must come down and conversely after a period of negative returns what's gone down must come up.

Brent Sheather is a Whakatane-based investment adviser.