Can we predict future returns from the past?

Can we forecast future returns from past results? The short answer is we can’t.  But there is a rational reason why equity markets outperform long-term.

The S&P, Dow Jones and Nasdaq, as an example. is just the biggest stocks in America.  The biggest firms though, change over time.  There is a survival of the fittest at play here.  With the exception of GE, no original company on the Dow Jones is still on it today.  The same thing applies to the UK FTSE100. It is just the 100 biggest firms in the UK, and the FTSE 250 is the biggest 250 firms in the UK.  

As we become more innovative, it gets harder and harder to get on the index and be one of the biggest firms in your country.  It was considered innovative 200 years ago to have invented a three wheeled car, after horseback went out of fashion.  These days, you might need to invent a car which is the most fuel efficient in history or can fly, to break into the top 100 companies in the US as a new company!

So the market is self cleaning.  Most businesspeople are confident about their own business growing, The same dynamic doesn’t exist for property or gold.  The supply of gold is quite stable, and demand goes up and down.  So it fluctuates, not losing or gaining a lot of value over long periods of time.  Ever the biggest gold bugs say gold is a good store of wealth, meaning it holds its value.  It does hold its value, but it doesn’t grow by much.

Housing has outperformed gold, especially since the 1980s, but the dynamic isn’t completely different.  Housing stock is relatively stable, unless a government decides to go on a huge house building program.  Demand is stable in smaller towns, and going up in big cities.  Long-term, the market can’t exist without first time buyers. As many first time buyers can’t buy now, there is only so far the market can go. 

So the conditions for growth exist in equities, which simply don’t for these assets.  If stocks are ever down over a 50 year period for the first time in history, moreover, then we are all in deep trouble.  No asset would be safe and democracy itself and the institutions we have gotten used to would be in trouble.  

This is because if stocks underperform for a short period of time, then sure other assets such as cash, gold or property can outperform without risking the whole system collapsing.    Stocks have underperformed before.  But the fact that the Institutions of the United States almost collapsed during the Great Recession, despite the fact that asset prices increased in real terms within a decade due to the deflation, should tell you what would happen if something much worse happened.  

Your property wouldn’t be safe from theft or confiscation if the economy was so bad in 2068 that the largest companies aren’t more efficient then than in 2018!  Your cash my not be worth much due to government efforts to stimulate this 50 year recession, and how much would government bonds be worth?

Barring a nuclear war or an absolute disaster, stocks will outperform other assets long-term.  If they don’t, we are all in trouble, and won’t gain from other assets if things ever got that bad.  

Adam Fayed – International AMG – adamfayed@iamgltd.com

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