Thursday, December 30, 2004

Future investment returns

Some nice discussion related to equity risk premia in the Economist. "...Despite the slump in prices in the three years to 2002, price-earnings (p/e) ratios still look a bit high, notably on American shares, and share valuations are unlikely to benefit from falling interest rates in future. Meanwhile, lower inflation means that the pace of profits growth will slow. Assume that America's nominal GDP grows by 5% a year (3% in real terms, plus 2% for inflation). If the share of profits in GDP is constant, profits will grow at the same rate. However, profits could do much less well, because in America, Japan and the euro area their share of GDP is close to a record high. They might well be expected to fall.

Suppose, though, that profits do rise in line with GDP and that p/e ratios stay the same. Then, Mr Barnes estimates, the total nominal return on American shares over the next decade will average 6.8% (5% profits growth, plus dividends), half the figure for the past 20 years. If profit margins fall modestly and the p/e ratio reverts to its long-term average, returns will average 4.9%—well below investors' expectations. Surveys suggest that individuals expect returns of more than 10%.

Could property instead lay the golden egg of the next decade? According to The Economist's global house-price indices, housing has yielded double-digit returns (including rental income) in most countries over the past 20 years. But the peak may be close. In several countries house prices are at record levels relative to incomes and rents. At best, they are likely to flatten off over the coming years. Add in the sharp fall in rental yields, and the prospective total return on property over the next five years or so is poor."

But, there is reason to believe that p/e ratios will remain higher than their historical average, due to investor confidence in the equity risk premium.


Anonymous said...

Actually the American REIT Index, taken back to the beginning of 1973, has been the best performing broad investment index, with the lowest degree of variability. Of course, the Morgan Stanley REIT Index was not available as a readily useable investment vehicle until a few years ago so the back extrapolations are a bit tricky. What is interesting about the REIT Index now, is that earnings growth for REITs has been negative for about 4 years. REITs are gaining in price as real estate prices rise, and not as rents or earnings of REITs from operations rise. Curious. What are we to make of this?

Anonymous said...

Anne, above and below :) I forget to sign with amazing regularity.

Sound macro-economic management is critical if we are going to count on the current S&P p/e ratios as a norm. Can we even expand the ratios? Why should a p/e ratio of 15 be more sound than 20 or 25 or 30? Is the critical factor simply low volatility? The p/e ratio was at 10 or below for about 8 years between 1975 and 1983. Before the short lived 1987 crash, the p/e ratio had risen to about 18.

Steve Hsu said...

It's interesting that you say REITs outperformed the house index in the first figure - were they smarter in choosing markets (i.e. avoiding the middle of the country where appreciation was less rapid), or did commercial real estate outperfrom housing?

Anonymous said...

I made a lot of money off of REITs (via Vanguard's REIT index fund).

However, the current valuations are nuts. As we all know, that's due to the low interest rate environment.

About REITs as a long-term investment: an important distinction is between land and improvements. In the long run, the scarce good is land. (Improvements are scarce only insofar as being limited to placement on land.) But it's not easy to invest in land itself.

REITs, like all real estate investments, have two return components: capital (that from improvements like buildings) and land. Thus, they do not represent an unambiguous way to invest in land.

Must-read pages for an understanding of the role of land in political economy are Are you a Real Libertarian, or a ROYAL Libertarian? and A Geolibertarian FAQ. These are from a "geo-libertarian" viewpoint which I don't share in its entirety, but they're good on many points.

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