The MSCI World equity total return index in US dollars is within touching distance of its 2007 all-time high, having risen by 131%* from a post-crisis low reached in March 2009. This strong performance, despite a disappointing economic recovery in the Group of Seven (G7) major countries, is attributable to three main factors.

First, equities were attractively valued following the 2007-09 bear market. According to a forecasting model** employed by US economist and fund manager John Hussman, for example, US stocks were priced to deliver a 10-year return of 9.2% per annum (pa) at the March 2009 trough – see first chart. The prospective return, admittedly, reached much higher levels in the 1970s and 1980s – it peaked at 20.0% in June 1982. The March 2009 forecast, however, was the strongest since 1992. Secondly, global growth has been respectable since 2009, despite a sluggish G7 recovery, reflecting the rapid expansion and increased weight of emerging economies. The IMF’s world GDP measure, calculated using “purchasing power parity” country weights, rose by 4.1% pa over 2010-12, above an average of 3.4% since 1980. The IMF expects continued respectable growth of 3.3% in 2013. World stock market earnings depend on GDP performance globally rather than in the G7.

Thirdly, the liquidity backdrop for equity and other markets has been unusually favourable since 2009, partly reflecting extreme and unconventional monetary policies. As previously discussed in these commentaries, a key liquidity indicator is the gap between the annual growth rates of G7 real (i.e. inflation-adjusted) money supply and industrial production. Faster expansion of real money than output implies that there is “excess” liquidity available to flow into markets and push up prices. This condition has been met in 34 out of 48 months since March 2009.

What do these considerations suggest about current equity market prospects? The trend rise in global GDP and corporate earnings should continue to be supported by emerging-world catch-up. The real money / industrial output growth gap, meanwhile, is still positive, though has narrowed in early 2013 as monetary expansion has moderated and the global economy has regained speed after a slowdown in mid-2012.

Equity market valuation, however, is now much less attractive than in 2009. According to the Hussman model, for example, US stocks are priced to achieve 10-year performance of only 3.0% pa, well below the historical average – first chart. Mr Hussman, therefore, has been suggesting that investors should hold cash rather than equities until an opportunity arises to lock into a less unfavourable long-term return.

Such an argument may be valid for US stocks but carries less force in other markets, where valuation appears reasonable. Applying a similar model to the MSCI World ex US index, for example, suggests a 10-year prospective return of 8.3%.

A further consideration, of course, is the lack of appeal of other investment options – particularly government bonds and cash. The prospective 10-year return of 3.0% pa on US stocks is 1.3 percentage points above the current yield on US 10-year Treasuries*.

Many fixed-income investors, moreover, achieve exposure via  funds that maintain a constant proportion of long-term securities rather than buying a 10-year bond to hold to maturity. They are, in other words, exposed to a risk of capital loss if either real yields revert to their historical average or inflationary expectations rise. A Hussman-type forecasting model suggests that a bond fund always investing in the current 10-year Treasury benchmark will deliver a negative return of 0.2% pa over the next 10 years, assuming that the real yield*** rises from its current -0.6% to 2.8% and inflationary expectations remain unchanged – second chart.
US equities, in other words, may be priced to deliver a modest return but still appear attractive to bonds. The two models suggest an equity return premium of 3.2% pa, above an average since 1960 of 2.6% – third chart. Valuation is the key driver of long-run performance but shorter-term equity market movements usually reflect the global economic cycle. A strong rally since mid-2012, for example, anticipated a pick-up in economic momentum in late 2012 and early 2013. This pick-up, in turn, was foreshadowed by faster global real money expansion from spring 2012 – the real money supply leads economic activity by about six months, according to the monetarist rule.

As noted earlier, real money growth has moderated recently, having peaked in late 2012. Allowing for the six-month lead, this suggests that the economy will lose momentum from mid-2013, a development that could trigger another bout of weakness in equity markets. This forecast is provisional  because monetary trends are not yet signalling a major slowdown and could revive, partly reflecting ongoing policy stimulus from the Federal Reserve and Bank of Japan.

Summing up, equities are much less attractive than in early 2009 but are nevertheless likely to outperform cash and government bonds by a significant margin over the long term. Investors seeking to deploy new cash, however, may wish to delay pending a possible economic slowdown later in 2013, which may create a better entry opportunity.

*As of 17 April.
**The model assumes growth in dividends, earnings and nominal GDP of 6.3% pa – based on post-war experience – and mean reversion of the ratio of market cap to GDP over 10 years.
***The real yield is calculated by subtracting the consensus 10-year inflation forecast from the current 10-year Treasury yield.