What we do know is that the average investor in South Africa demands a real (after-inflation) return from equities of around 7% pa. This return is based on a risk-free hurdle rate of 2% to 3% and an equity risk premium of 4% to 5%. Investors also want to offset inflation, whatever that may be.
This required real return is observed rather than specified. It can be seen in the long-term real return delivered by listed equities in South Africa or derived from the long-term average earnings yield of the SA stock market.
Investors have earned much more than 7% pa in recent years: the FTSE JSE All Share Total Return Index has grown at c.16% pa over the past five years. Admittedly, this return comes off the global equity melt-down in 2008, but even considering just the last three years, investors have earned nearly 14% pa (before fees), double the average rate.
Much of this return is due to our market’s re-rating which, we believe, is not driven by the earnings outlook, but by the erosion of the risk-free rate globally. This lowers the discount rate for equity investors: future cash flows then become more valuable, even if they are not expected to increase.
As long as we are stuck in this phase of low growth, low(ish) inflation and low real interest rates, investors will look to equities for a real return. Some call this the “new normal“; if it persists, we would expect equity returns to moderate but not necessarily turn negative in a big way.
Ironically, signs of an economic recovery (beyond the expectations priced in) will be bad news for share investors. It suggests that interest rates will rise, along with the discount rate applied to future cash flows. Although these cash flows may improve as the economy grows, they will become less valuable. We would then expect a degree of mean reversion, and for the share market to give back some of its gains.
We can also envisage a less benign scenario, where interest rates increase on the back of rising inflation rather than economic growth. This may happen due to excessive rand weakness, for example. The effect on our share market would then be much more severe.
But we have no idea which scenario will play out next year. Although the market is fairly efficient in pricing in the required real return – to the extent that investment strategists invariably forecast a one-year total market return of around CPI +7% – it almost never delivers this return over the subsequent twelve months. Why not?
Three things determine the one-year market return: the reported earnings over the next twelve months, the dividends paid out and the exit rating (market PE) at the end of the year.
As a group, analysts do a reasonable job forecasting the next twelve 12 months’ earnings and dividends, as the underlying drivers are already in motion. But these estimates are already priced in, and therefore play little role in next year’s return.
Visibility deteriorates beyond twelve months. A big question mark therefore hangs over the market’s one-year exit PE ratio. By December 2014, it will discount a host of factors, all of which are still unknown – actual earnings and dividends in 2014; financial, political, economic and regulatory developments; the likely impact of these on inflation, interest rates and the currency; and ultimately how all of this could impact earnings and dividends, and the discount rate in 2015 and beyond.
These variables may combine in any number of ways. It is complete hubris to assign values, probabilities and time lines to each, and to invest according to these inputs, jumping between asset classes, and moving in and out of the market.
Yes, investors can learn to identify asset classes that appear cheap or expensive, but this does not mean they can predict the turns. Markets invariably run longer and rally sooner than we expect; yet missing the turns makes it almost impossible to match the average market return, let alone exceed it.
Studies in the US have compared net fund returns with the average net investor returns; investors typically lag by around 3% (percentage points) pa, because they believe they can time markets. These investors would have been better served with a simple “buy and hold” strategy.
So, rather than speculate on next year’s return, investors should focus on their asset allocation. They should base this on their investment time horizon, not on what appears cheap or expensive. They should find the most effective and cheapest way to own these asset classes and diversify adequately. They should stick to the plan and re-balance as required.
Above all, they should ignore what industry “experts” have to say on the current market level and what the next twelve months hold in store. Because these experts – like the rest of us – simply don’t know.