What influences market returns in the long term?

Following on from our previous newsletter where we discussed current market trends, there are important factors that influence market returns over the long term. By understanding the inter-relationship of these factors we are able to get a better insight into what sort of long term average returns we can expect and how we are able to better position your portfolios for the road ahead.

Does economic growth always drive stock market returns?

In short, there seems to be no satisfactory statistical relationship between economic growth and stock market performance. There is no doubt that there is an indirect affect as economic growth can drive corporate earnings which in turn influences share price. However, there have been plenty of times where above average economic growth resulted in poor market returns and vice

In a 2001 Fortune excerpt, Warren Buffett tackled this subject and pointed at the following facts:

Between 1964 and 1981 the DOW Jones returned 0% versus a stellar economic growth of 373%.
Between 1981 and 1998 the DOW Jones returned 950% while economic growth rose only 171%.

The main explanation for this divergence comes down to two important variables – interest rates (as indicated by long term government bond yields) and corporate profits.

Dec 1964: 4.2%
Dec 1981: 13.65%
Dec 1998: 5.09%

While we do not see many regions of the world hiking interest rates any time soon, the US may be on the cusp of this tightening process towards the end of this year. This action has large implications on world markets and we caution our clients from taking too much risk at this market cycle. On the positive side, we believe that the US Federal Reserve is unlikely to shock the financial system by raising rates too fast. Given the large degree of vulnerability in Europe and Japan, the Federal Reserve is aware of the possible consequences of such a move.

The inevitable rate rise in the US

We have often mentioned to our clients that, in general, humans tend to extrapolate recent experiences and forecast that far into the future. At the moment, many economists and analysts alike are seemingly fixated on the low rates and see no end in sight to the historical low yields. Many are brushing aside what seems to be darker clouds coming our way in the form of a US interest rate hike. When that will happen, we cannot speculate.

Investors may question how a rate rise in the United States will affect companies and their share portfolio here. To be simplistic, many companies around the world, especially those in Asia and those with revenues derived from overseas, often borrow in US dollars. When the US raises rates, companies are effectively paying more interest on their US dollar loans. On top of that, if the US dollar increases, they receive a double whammy. This leads to lower income and more conservative earnings projections, all leading to lower market expectations and lower share price.What’s interesting to note is that throughout the last century we have experienced nineteen US rate hikes and in sixteen of those periods, the stockmarket declined by an average of 16%.

In light of the above, we caution you not to invest heavily at this juncture. We would advise taking
some profits off the table and keeping at least ten percent in cash or a safe alternative.

Disclaimer: This publication has been compiled by Financial Decisions (AFSL/ACL Number 341678). Past performance is not a reliable indicator of future performance. Whilst every effort has been taken to ensure that the assumptions on which the outlooks given in this publication are based on reasonable data, the outlooks may be based on incorrect assumptions or may not take into account known or unknown risk and uncertainties. Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter nor relied upon as such. The information and any advice in this publication do not take into account your personal objectives, financial situation or needs. Therefore you should consider its appropriateness having regard to these factors before acting on it. While the information contained in this publication is based on information obtained from sources believed to be reliable, it has not been independently verified. To the maximum extent permitted by law: (a) no guarantee, representation or warranty is given that any information or advice in this publication is complete, accurate, up-to-date or fit for any purpose; and (b) Financial Decisions nor its employees are in any way liable to you (including for negligence) in respect of any reliance upon such information or advice.

Contact: Financial Decisions PO Box 484 Mona Vale NSW 1660, T 02 9997 4647, F 02 9997 7407