Summer is a good time to take a step back from the daily fluctuations on the financial markets and think about trends that could affect the financial environment in the next few years. The exercise makes even more sense this year, as the markets seem to be mainly driven by technical considerations while they wait for fundamentals to gain the upper hand.

It seems impossible today that the stock markets could return to their early 2009 levels, or even fall further, just as in October 2007, it seemed impossible that the markets could slump 60% over 18 months, or in March 2009, that they could shoot up by 70% in the space of one year. Investors tend to base their strategies and return expectations on their recent experience. At the start of the 1980s, after 15 years of virtual stagnation in share prices coupled with significant volatility, people were not interested in stocks. On the cover of its August 1979 edition, BusinessWeek magazine proclaimed the “death of equities” (‘The Death of Equities. How inflation is destroying the stock market’). Twenty years later, the Dow Jones had risen to 11,500 from 840 and investors’ faith in the markets was such that equities were considered by far the best long-term investment.

One interesting aspect is that despite a very bad decade for the stock markets during which they strongly underperformed the money and bond markets, the cult of equities still seems to be thriving. Given that the slightest technical rebound sends investors shooting back to the markets, equities have never really corrected their massive overvaluation of the end of the 1990s and remain at much higher valuations than those that led to the great bull markets of the past. At the start of the 1980s, US stocks were trading at six times earnings and paying an average dividend of 6%. Today, despite 10 years 'for nothing’, they are still two to three times more expensive. Some attribute higher equity valuations to the current low interest rates. As well as diminishing the attraction of the main alternatives to equities (cash and bonds), low interest rates also increase the present value of a company’s future earnings (earnings of €1 million in 2020 have a present value of €386,000 when discounted at a rate of 10% and of €614,000 when discounted at 5%) However, the low interest rate argument does not detract from ‘the price paid determines the return’ principle, nor does it alter the fact that when equities are bought at 20 times earnings, we should not expect the same return as if we paid 10 times those earnings. In other words, saying that equity valuations are attractive because of the low level of interest rates is tantamount to saying that equity returns should be higher than those of fixed-income investments in the coming years. Empirical studies show that an investor buying the US market at its current valuation in the past would have on average obtained a real annual (inflation-adjusted) return of around 3% in the following 10 years. 3% is indeed better than the return to be expected from a money-market or bond investment: the average yield on a German Bund or US Treasury bond is currently around 2.5% (to reach a real return of 3%, there would thus have to be annual deflation of 0.5%). Nevertheless, 3% seems to me to be well below the figure investors have in mind when they buy stocks.

Using the argument of low interest rates to justify investing in stocks also seems rather audacious when the low level of interest rates is due to an extremely fragile economic and financial environment, as is currently the case. The decline in interest rates and the rise in valuations in the 1980s and 1990s was due to falling inflation and improving economic fundamentals. Today, these fundamentals are deteriorating and interest rates cannot fall a lot further. This is hardly an ideal environment for valuation multiples to rise. One often reads that stock markets have corrected their valuation excesses and that multiples are reasonable (in the case of the United States) or even cheap (in the case of Europe). The argument being that, based on the most commonly-used equity valuation measure, the Price/Earnings ratio (PE), the markets are trading today at lower multiples than the historical average. This prompts two observations. First, this argument is only true if the denominator used in the PE ratio is 12-month forward earnings estimates. In the past such estimates tended to be far too optimistic. Moreover, they exclude non-recurring charges. The next point is that while the average long-term PE ratio is around 15, the reality is that equities rarely trade at 15 times earnings. In practice, periods during which stocks are more expensive (PE above 15) tend to alternate with less expensive periods (PE below 15). In other words, the idea of "mean reversion" implies that when markets have been overvalued for a long period (as was the case throughout most of the past 20 years), they have to 'pay the price’ in the following years by trading at below-average multiples. Take a company with earnings per share of $1 and trading at 20 times earnings (PE of 20), i.e. $20. If, five years later, its earnings per share have risen by 50% (to $1.5) but the market is only willing to pay 10 times earnings, the share price will be $15 (a fall of 25% in value).

It is possible that we will see this kind of multiple compression in the coming years. The fall in interest rates that resulted in higher multiples in the 1980s and 1990s has practically run its course. Inflation is close to zero and could soon turn into deflation (unlike falling inflation, deflation is bad news for the stock markets. History shows that once inflation drops below 1%, valuation multiples fall). The economic recovery remains very fragile: the high level of debt and the deterioration in public finances are weighing on growth in the industrialised countries. The fact that the problem is mainly on the demand side increases the deflation risk even further, especially given that although governments have managed to offset the weakness in economic activity in the private sector by increasing public spending, this may no longer be an option given the scale of budget deficits. If the economy slows again and falls into recession, there will come a time when the authorities will have no ammunition left to kick-start growth.

I think that if current ranges (~1000-1200 for S&P500, ~225-275 for DJ Stoxx 600) can hold for a little longer, the next significant move on the stock markets will be down. Traditional economic indicators (such as employment and retail sales) clearly show that the United States is not experiencing a classic recovery. As well as this, the positive impact of stimulus measures are starting to wane, the housing market is starting to decline again and recent figures show that there has been a relatively significant slowing in economic activity.

I have written many times that the upside potential for stocks (in the industrialised countries) for the next three to five years seems limited from current levels and that an investment strategy should focus on the ‘return' aspect - i.e. dividends. Of course, buying a stock for an annual dividend of 5% is much less exciting than buying for a quick 20% gain. However, it is interesting to note that the dividend theme is starting to take on increasing importance with both companies (according to Barron's magazine, the ratio of US companies increasing their dividend and those lowering it is currently 9:1) and investors, judging by capital flows that show that the quest for regular returns is rapidly becoming a secular investment theme. Demographic trends should speed up this trend as ageing baby-boomers are less inclined to take risks and tend to be more reliant on regular returns to finance their retirement. From this point of view, the fact that the dividend yield on the S&P 500 is currently around 40% below its historical average is not a good sign for the market overall.