Equity markets across the world continue to struggle. The indices of most developed countries remain below the level they were at in 2000 when the 20th century ended. Many investors are worried that stocks will continue to provide inferior returns for years to come. Unfortunately, they may be right.
Historical Returns to Stocks and Bonds
Equities reflect the present value of future earnings and free cash flow to a corporation. If investors anticipate that future earnings will rise, stock prices rise, but if investors anticipate a decline in future profits, share prices will fall.
This changed in the 20th century. As countries abandoned the gold standard and allowed their paper currencies to inflate, share prices rose (often accompanied by numerous stock splits). As governments grew in size, so did taxes, and in countries where income taxes on dividends exceeded capital gains taxes, investors benefited from allowing corporations to reinvest profits that generated capital gains. As illustrated in Figure 20.2, anticipation of future capital gains led to price/earnings (P/E) expansion as investors anticipated rising earnings. Finally, as central banks manipulated interest rates to influence the economy, lower interest rates made equities more attractive contributing to the rise in equity prices.
Could the 21st century be reverting back to the condition of stock markets in the 18th and 19th centuries when the capital gains on stocks were minimal or non-existent? Unfortunately, the answer to this question could very well be yes.
Japan’s Two Lost Decades
Japanese investors saw little or no return between 1990 and 2015. As illustrated in Figure 20.3, from 1950 to 1989, Japan had one of the best-performing markets in the world when the annual return to stocks and bonds was 14.24% per annum. The phenomenal growth in equity returns occurred as Japan’s economy caught up with the rest of the world after the devastation of World War II. Since 1989, stock prices have declined dramatically, showing an annual decline of 1.1% between 1989 and 2015. At the end of 2011, the Nikkei was at the same level it had been at in 1986, almost 30 years with no change in stock prices. Moreover, the trendline on Japanese equities remains down. With the yield on Japan’s 10-year bond actually turning negative in 2016, bonds provide a poor alternative to equities which provide a 2% dividend yield. With the Yen appreciating against other currencies, the return from foreign investments to Japanese investors is reduced. Is this the fate of investors in the rest of the world in the century to come?
This is illustrated in Figure 20.4. The Price/Earnings Ratio for Japanese stocks was between 10 and 15 during the 1960s, but rose after that to 70 in 1989 when stock prices peaked, and to almost 100 in 1995. This allowed the price of stocks to increase faster than earnings. Since then, this trend has reversed. Once again, the P/E Ratio lies in the 10 to 15 range as it did in the 1960s. This at least means that the prices of Japanese stocks are unlikely to decline further unless the earnings of Japanese companies decline.