With the banks offering pitifully low interest rates, more investors are switching their attention to the stock market, says Ian Cowie.
By Ian Cowie 8:27PM GMT 15 Dec 2010
Most people regard inflation as a bad thing, and many may be puzzled about why the stock market is hitting new highs at the same time that inflation is accelerating. The explanation is that while inflation robs savers in bank and building society deposits by reducing the real value or purchasing power of the money they set aside, investors in shares can point to more than a century of evidence that this way of storing wealth can cope with rising inflation by increasing dividends and capital growth.
Savers have good reason to resent being punished for their thrift. Some may feel even worse when they realise that the Government is one of the beneficiaries of inflation, because it not only reduces the real value of savings but also of debts – and the Government is the biggest debtor in Britain.
With a massive deficit in public finances, gradually debauching the currency appears to offer a relatively painless way to float off the rocks of debt. Pensioners are less likely to protest about the stealthy erosion of their savings than younger people are to riot about reduced state handouts or higher interest rates. The problem is that trying to have a little bit of inflation is like trying to get a little bit pregnant; things soon get out of hand.
For example, just over a year ago – in October 2009 – the Retail Prices Index (RPI) measure of inflation was actually negative. The annual rate of change was minus 0.8 per cent and had been minus 1.4 per cent the month before. By contrast, the RPI is now rising at 4.7 per cent.
If that sounds like small beer compared with inflation seen in the 1970s, then beware: even today's rate of erosion would be enough to halve the purchasing power of money in little more than 15 years. That's much less than the 22 years and six months the average man can now expect to spend in retirement, according to the Office for National Statistics. Or the 24 years and eight months that awaits the average woman at retirement. So there is nothing theoretical about the problem inflation presents to pensioners.
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Worse still, the Government plans to reduce the indexation – or statutory protection against inflation – that pensioners receive in future. From next April, all public sector pensions will be uprated in line with the Consumer Prices Index (CPI). This produces a lower measure of inflation by excluding mortgage costs and council tax and is currently rising at 3.3 per cent. From April 2012, the Basic State Pension will also switch to CPI.
Cynics argue that rising inflation should come as no surprise, since the Government's main tool for fighting the global credit crunch has been quantitative easing – akin to printing more money. The signs were also there when the Bank of England switched most of its staff pension fund into index-linked or inflation-proofed government gilt-edged stock, as reported by the Telegraph in April last year. And when National Savings & Investments abruptly ceased selling index-linked certificates in July, that removed the only risk-free way for individuals to protect their savings from inflation. Talk about taking the umbrella away, just as it started to rain.
Fortunately, history offers some comfort for those willing to accept varying degrees of risk in order to preserve the purchasing power of their money. According to Barclays Capital, shares reflecting the broad composition of the London Stock Exchange have provided greater real returns than deposits over three quarters of the periods of five consecutive years since 1899. Shares also beat fixed-interest bonds in 75 per cent of all those five-year periods during a century which, remember, included the Great Depression and two World Wars.
While the past is not a guide to the future, the historical evidence shows that the probability of shares doing better than bonds and deposits increased over longer periods. For example, over all the 10-year periods, shares delivered higher returns than deposits 92 per cent of the time, and beat bonds 80 per cent of the time. But shorter term stock market speculators took bigger risks – for example, deposits did better than shares in a third of the periods of two consecutive years.
Against all that, perennial pessimism remains the easiest way to simulate wisdom about stock markets. That's why many experts have been calling the top of this market all the way up. Despite having missed the start of this bull run, they argue that shares are now too high – even though they do not look expensive on some tried-and-tested means of assessing value. The average price of the shares that constitute the FTSE 100 index is now 12 times their average earnings per share. By contrast, the same price/earnings ratio exceeded 31 by the time the FTSE hit its all-time peak of 6,930 in December 1999.
More importantly for income-seeking savers, the average yield – or the dividends paid by shares expressed as a percentage of their price – is now slightly above 3 per cent. But, when prices soared to unsustainable levels a decade ago, the yield on the FTSE 100 slumped to less than 2 per cent.
It's worth stressing that the yield on shares is quoted net of basic rate tax, so 3 per cent net is even more attractive than it may at first appear by comparison with bank deposits, which are quoted before tax. The FTSE 100 yield is also six times Bank of England base rate and, while returns on deposits remain frozen and inflation continues to rise, there is every chance that the FTSE 100 could hit 6,000 soon.
If that sounds far-fetched, here's what I wrote in The Daily Telegraph in August 2009, while the index still languished below 5,000: "After all the worldly-wise men's warnings of a double-dip recession, it should be no surprise to see the FTSE 100 soar. If anything, the continued consensus among most market observers that this remarkable rally has 'gone too far, too fast' should boost our hopes the index will breach 5,000 soon.
"The reason is that economies tend to grow over time and shareholders own the companies that create this wealth. So, medium to long-term savers – like those of us saving toward paying off the mortgage or funding retirement – need not worry too much if share prices fall next month. That might be a problem for fund managers, who must answer to a board of directors every few weeks, and an opportunity for the rest of us.
"Finally, it is worth considering the personal anxiety of many professionals who are now 'short of the market' or holding cash rather than shares. They can only afford to sit and watch prices rise for so long before they feel compelled to join the fun and keep their jobs."
Shares and share-based funds are not as cheap as they were in August last year. But, as more people have come to feel that the credit crunch is not the end of the world after all, the penny has dropped and inflows of capital from bank deposits into the stock market have pushed prices up.
That raises the risk that buyers today could lose money if prices fall. This is a real danger with shares, which means nobody should invest cash they cannot afford to lose in the stock market – and, as mentioned earlier, the shorter your time horizon, the bigger the risks.
Two ways to diminish these risks are to commit funds for five years or more and to diversify.
By contrast, frozen interest rates and rising inflation mean most supposedly risk-free bank and building society deposits are now a certain way to lose money slowly.
There is little point saving if returns fail to match the rate at which inflation erodes the purchasing power of money. So, while shares and share-based funds offer no capital guarantee, rising numbers of people who must live off their savings or use them to supplement pensions should consider some long-term exposure to shares and share-based funds.
http://www.telegraph.co.uk/finance/personalfinance/comment/iancowie/8204914/Is-it-time-to-take-a-chance-on-shares.html
