No reason to be too gloomy

The difficult thing to do at the moment is to separate short and long term influences in the global share markets. My judgement is that accounting issues are no longer the key issue. They are in the market and probably overly discounted. The GDP accounts tell us profits are not about to collapse. So in the short term it is hard not to be optimistic.

Most measures of sentiment indicate very gloomy investors, general capitulation and oversold markets. The very fact that we are seeing an increasing number of gloomy predictions about decade long bear markets suggests an end to equity complacency.

Here is a sensible way to think about the issue longer term. Anyone who could do basic arithmetic has realised that equity returns over the next decade would inevitably be much weaker than those since the bull market started in 1982.

A simple measure, such as adding the earnings yield to trend growth suggested returns in the 7-9% range. What we are witnessing is that not all investors had appreciated this, and/or that in a low return world return volatility can obscure the upward trend in markets for long periods.

Therefore, asset prices have to adjust to the point where enough investors are prepared to hold enough risky assets in their portfolios in the required quantities. At what level this happens is impossible to say. The fact that both institutional and retail equity weightings are already high, and that equity market volatility shows no signs of diminishing, argue that the risk premia needs to be much larger than that prevailing at the height of the bull market.

The good news is that this has already happened to a large degree. Measuring the equity risk premium is difficult, but by our measures it was around zero globally two years ago.

Today, the earnings yield is above bond yields in all major markets. When combined with healthy economic growth there is little doubt that investors will be better off in equities than bonds over the next decade.

Which would you rather own? Government bonds yielding 4.75% for the next decade or equities yielding 5% with 3-4% growth per annum? When enough investors do that arithmetic markets will stabilise.

We suspect that point is not far away.