Valuations are the core determinant of equity market returns.

Reason to hope for stock market investors
The "brutal" lesson will can learn from the past 10 years is that valuations are the core determinant of equity market returns.

By Paul Farrow
Last Updated: 12:14PM GMT 23 Feb 2009

John Maynard-Keynes: 'Success is always to the minority and never to the majority'
It is official. Equities were the worst performing asset class over the past decade, delivering negative real returns since 1998.

I don't suppose that those of you who have owned shares, unit trusts or Isas over the period will be too surprised at the revelation.

Unless you had been canny and bagged profits when they came and timed your run into commodities or emerging markets (and got out again) – or followed the gold bugs – you would have been a loser.

Fund statements that will have landed on doormats over the past year will have made for grim reading, while workers who are in defined contribution pension schemes have just learned that their pension fund has fallen in value by 25pc last year.

Consensus on where equities go from here is difficult to gauge, although the bears seem to outnumber the bulls. Investors seem to be shunning equities in favour if bonds.

Many advisers are once again advocating the merits of diversification – in other words, if you had invested in other assets such as cash and bonds, you would have fared better than someone who was overexposed to equities.

Yet not everyone believes diversification is the name of the game. Gary Potter, a multi-manager at Thames River, is one who argues that the crisis has narrowed the correlation between assets, making diversification less of a benefit.

He is happy to remain overweight in cash for the time being.

Some might be proclaiming the death of equities, although such thoughts could be premature.

It is easy to be sceptical about shares right now given their woeful performance, but the analysts who have just finished writing the 2009 Barclays Equity Gilt Study give reason for hope.

Firstly, the underperformance of shares has nothing to do with the asset class per se. Secondly, it says the macroeconomic environment has little influence on shares, which is a cheery thought given the deepening global recession.

Even corporate profitability, you might be surprised to learn, isn't the deciding factor on whether a share outperforms or not.

The study concludes that the "brutal" lesson will can learn from the past 10 years is that valuations are the core determinant of equity market returns.

Its research suggests that the reason shares have had such an abysmal ride over the past decade is that they were overvalued. Through the good times we were paying too much to get access to bumper profits.

"When the surge in growth ended abruptly in 2008, equity prices fell in line with the actual and expected decline in profits.

Expensive valuations therefore caused equity returns to underperform profits following the 2001 slowdown and then did the same during the ensuing boom, while finally failing to provide a cushion when the business cycle turned down," the study concludes.

You can probably guess where the Barclays mob are going with this, so if you are considering stuffing your spare cash under your mattress, keeping it in a savings account despite the dismal rates of interest, or even following the herd and piling into bonds, then bear this in mind.

The authors of the study believe that equity valuations will fall a little further and remain low for a while, before recovering late in the decade. Meanwhile, bonds' rising yields will "self-evidently" damage returns. The end result is that equities will outperform bonds over the next 10 years.

The contrarian argument put forward by Barclays might whet the appetite of those yearning for some optimism. Those optimists might also want to be reminded of this post-Depression scribbling from John Maynard Keynes, the most famous contrarian investor of them all.

In 1937 he wrote: "It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind."

http://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/4786377/Reason-to-hope-for-stock-market-investors.html