A (very) long-term look at US equities
Monday, November 3, 2008 at 02:50PM
Simon Ward

The US stock market is at its lowest level relative to its long-term trend since 1984. This argues for a strategy of gradually increasing equity exposure - unless the trend is believed to be in the process of changing.

The chart below shows an index of inflation-adjusted equity returns since 1800 together with a trend line calculated on data up to 1999. The slope of the line implies an impressive real return of 7.1% per annum.

Interestingly, an almost identical line could have been estimated in 1950, based on data until then. The slope would again have equated to a real return of 7.1% pa. A simple extrapolation would have been a superb guide to real equity returns since 1950. Moreover, an investor could have beaten the market by increasing equity exposure when the return index moved below the line and cutting back when it rose above.

Consider someone updating the calculation in 2000. Such an investor would have concluded it was a poor time to own equities, even assuming the long-term trend would be sustained. The deviation between the return index and the trend line reached 82% in December 1999 - a level exceeded only in 1929.

The return index fell to touch the line at the bottom of the 2002-03 bear market, suggesting an investor buying equities at that point would earn the average 7.1% real return over the long term. The subsequent recovery restored a positive deviation, however.

The sharp fall of recent months has pushed the return index 48% below the line - the largest negative gap since 1984. While this appears to present a buying opportunity, deviations are often prolonged and can be more extreme than currently. This suggests adding gradually to equity holdings rather than moving straight to a maximum position.

Of course, the risk is that the trend is in the process of shifting lower from its historical 7.1% pa - such a change would not be clear in the data for several decades. However, its impressive stability despite major economic and political upheavals over the last 200 years offers reassurance.

Article originally appeared on Money Moves Markets (http://moneymovesmarkets.com/).
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