Equity paradigms challenged

A number of new research articles have deunked two universally held beliefs in the investment industry, that shares are a good long-term bet and that economic growth is good for equities. Dr Arjuna Sittampalam, Research Associate with the EDHEC-Risk Institute and editor, Investment Management Review, examines the research.

It is a well-entrenched paradigm that, whatever happens in the short term, equities are always a good bet for the longer term. Academic evidence strongly suggests otherwise.

Underlying this notion is the belief that dividends and earnings will obviously rise in line with GDP. However, a study produced for Credit Suisse by academics Elroy Dimson, Paul Marsh and Mike Staunton shows that since 1900 global dividends have shown real growth of only 0.7 per cent a year, whereas global economic growth has been five times this rate. US dividends, for example, have gone up only three times since 1900, compared with a 20-fold jump in the US economy. Japanese figures are even more shocking. A 40 times increase in the economy has been accompanied by a shrinkage of 90 per cent of dividends after inflation.

These statistics may well seem to violate intuition, as equities are widely expected to mirror economic growth, if not actually to outperform it, given the extra risk.

A cogent explanation was provided by the well-known industry commentators William Bernstein and Robert Arnott. Their explanation lay in the issuance of new shares. More than half of economic growth is produced from innovative developments and new enterprises. These enterprises and developments come into being through share issuance by both new companies and existing companies. This effect of entrepreneurial capitalism, the engine of economic growth, has led to earnings per share underperforming corporate profits and, in practice, GDP. The authors supported this conclusion by describing two independent analytical methods based on share and economic data dating from 1871.

Though some of these studies have been based on earnings and others on dividends, Dimson, Marsh and Staunton’s view is that these two have tended to track each other. Tony Jackson, a regular FT columnist, concludes that the cult of the equity is pretty fragile.

Bernstein and Arnott also questioned whether outperformance of GDP by corporate profits could be sustained indefinitely. Perhaps they did not go far enough, however, because there are signs that this effect might go into reverse in the coming years. Corporate profitability has improved in the last two decades.

The world has now entered an era of re-regulation, with hints of protectionism and deglobalisation, together with a questioning of the merits of capitalism. It is on the cards that labour will start clawing back some of the increasing share of the global economic pie that the owners of capital and entrepreneurs have grabbed in the last several decades.

Furthermore, matters could be much worse. They pointed out that the revaluation effects, responsible for a substantial part of equity returns in recent decades, cannot continue. If dividends and earnings growth cannot exceed inflation by anything but a small margin, then there are indeed profound implications for the valuation of equities. In actual fact, as the market recognises the diminished expectations for equity earnings, the upward shift in valuations of the last 20 years could go into reverse with a seriously negative impact.

If equities do not prosper from economic growth, at least is there a case to consider this asset class as an inflation hedge? Dividends and earnings having out-performed inflation, albeit by a small margin, might be cause for hope. But the smallness of the margin does not suggest that too much reliance can be placed on it. Moreover, in the short-to-medium term equities can underperform inflation as price/earnings ratios turn downwards in response to higher interest rates accompanying the inflation.

Backing equities for the longer term is currently an axiom among financial planning advisers for individuals and asset allocators for larger investors. History does not bear this out. After the Dow Jones peaked in 1929, it took 25 years for it to recover on a sustained basis, with similar episodes punctuating the history of the nineteenth and twentieth centuries. The studies outlined above provide strong empirical justification for challenging the view that equities are best in the long term, and Bernstein and Arnott’s paper provides theoretical ballast.

Economic growth bad for equities

The bounce in stock markets this year on the back of the green shoots of an economic upturn are taken to be a reflection of this universal belief that economic growth is good for equities. Emerging markets have done particularly well in response to their high growth prospects.

According to Elroy Dimson, this is all wrong. He found that the economies growing the fastest produced the poorest equity market returns by a large margin. His study, based on decades of data from 53 countries, showed that equities in the highest-growth countries produced a return of 6 per cent per annum on average, while the corresponding figure for those with the slowest growth was double that at 12 per cent. These findings caused a shock when Dimson presented them at Yale University.

Additional evidence has been produced by J. Ritter of the University of Florida, who claims that the correlation between GDP growth and equity returns across 16 countries from 1900 has been strongly negative.

There are structural reasons for this negative correlation with growth. The article above described why equity returns under-perform economic growth. Dimson’s study bears out the previous study by Bernstein and Arnott in the Financial Analysts Journal referred to above.

The latter also showed that in the countries severely damaged by the wars of the 20th century there was greater dilution in equity performance for existing investors than in the other group of countries. They explained this by pointing to the recapitalisation required to restore war damage. They went on to extrapolate this to the impact of technology, by saying that technology has the same effect as war in making old equipment obsolete and requiring massive new investment.

Ritter echoed the Bernstein and Arnott study, by saying that high growth leads to new companies and extra employment, which is good for the local workers but not so good for investors. Last year, the fact that six of the world’s 10 largest IPOs were in emerging markets, and that up to 30 June this year Asia, Latin America, the Middle East and Africa accounted for nearly 70 per cent by value of all IPOs worldwide, provides empirical support for the theoretical arguments. Growth in the emerging market countries will be spread amongst an ever-increasing number of investors, with all the dilution that implies.

The previous article made the case for equities being in general likely to under-perform economic growth. This article goes even further. It provides strong empirical evidence that the higher the growth, the worse it might be for equities. These two articles in combination should lead to a massive rethinking of the role of equities in long-term growth portfolios.

It is interesting that equity markets worldwide this year have been taking off at the first visible buds of economic recovery. Emerging markets in particular have boomed on expectations of strong growth and de-coupling from the troubled western economies. Both these developments seem unwarranted, on the basis of the evidence.

Given the arguments presented, perhaps it might be better for equity players to prefer a sluggish or even flat economic environment, as opposed to a growing economy, causing damage in the way described, or a falling economy, harmful in other ways.

The two articles principally undermine the case for indexation in equity markets, given that all the evidence is based on indices. Talented stock pickers identifying good companies for the long term could override the effects of the theory. Also, while “buy and hold for the long term” is out, there might be a case for more trading and market timing for those who can do it successfully. Possible implications for the industry are outlined below.

Will the cult of the equity die?

Asset allocators are still coming to terms with their diversification strategies failing during the credit crisis. Supposedly uncorrelated markets all declined in unison. But fund managers might have to contemplate a much bigger problem, with far-reaching ramifications for industry structures and practices.

As we have seen above, two cherished paradigms are under serious assault from academia. One is that economic growth is good for equities, and the other is that, irrespective of the short term, equities are a good long-term bet.

Had the evidence against these two beliefs come from just one source, the industry could perhaps overlook it as an aberration. But several authoritative academic studies coming to similar conclusions from different angles must merit serious consideration. And particularly so given that the research stretches over a century and across many countries.

Both the empirical and the theoretical case have been made that equity dividends and earnings fall well short of GDP growth and that the higher the latter, the lower the former. A get-out clause lies in the fact that all the studies are based on indices and therefore cannot apply to individual stocks, or even to groups of selected equities – consider Microsoft or Tesco, for instance. The research undermines passive management and thus suggests that, for equity investment, active management might offer the best chance.

It is fascinating that the airing of this evidence has coincided with the coming under the spotlight of the validity of the Efficient Market Hypothesis (EMH), the antithesis of active management. But, irrespective of this debate, the index is beaten only by a minority of asset managers, to whom the industry as a whole cannot have access. The majority of investors cannot rely on active management to counter the poorer long-term expectations for equity indices indicated by the research.

Should asset managers in general take these results on board, profound implications arise for the fund management industry. Equities have hitherto been considered a core holding in the portfolios of many investors, even risk-averse ones. This might be reviewed.

Until many decades ago, bonds were the investment vehicle of choice for most risk-averse investors, with the equity cult taking hold only in the last 50 years or so. A reversion to the earlier preference might come about.

The problem is that conventional bonds are not particularly safe, given the spectre of inflation. Moreover, their index-linked counterparts are not plentiful enough if too many investors go for them. Over the longer term, equities have some inflation-hedging properties, as the studies suggest, and this could be of long-term value, though dubious in the short term. Furthermore, inflation protection is also offered by rival direct investment in property, commodities and infrastructure.

The asset management industry’s inertia is such that it is not prone to abandoning conventional wisdom rapidly, even when a compelling case arises for doing so. Nevertheless, if at some point the penny drops that quoted equities have poorer long-term prospects than thought, then the shape of the industry could undergo a mind-boggling transformation.

The structure of many investment companies with a bias towards equities might change. Extensive industry investment in passive equity vehicles would come under threat. A future can be contemplated in which intrepid hedge funds and adventurous private individuals are largely equity players while the institutional world, including mutual funds and pension funds, focuses much more on safer strategies, with a considerably reduced exposure to equities.


“Will the cult of the equity die?,” “Shares poor long-term bet and “Economic growth bad for equities,” Investment Management Review, Vol 5, Issue 1, autumn 2009.

“Dividend shadow of former self and future uninspiring,” Tony Jackson, Financial Times, 01.06.09.

“The long-term outlook for equities – will technology hurt?”, Investment Management Review, Vol 1, Issue 1, April 2005.

“Earnings growth: the two percent dilution,” William J. Bernstein and Robert D. Arnott, Financial Analysts Journal, September-October 2003.

“Taking a look under the curtain,” Jason Zweig, the Wall Street Journal, 27.07.09



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