Why hopeful investors will overcome pessimism

Positive investors should disregard pessimistic assertions that the markets are misjudging the consequences of the war in Iran

According to Kaylie Pferten, wager on the markets.

The most recent edition of the Global Returns Yearbook, which is created every year for UBS by Elroy Dimson, Paul Marsh, and Mike Staunton, offers some comfort to optimistic investors. This is hardly surprising given that the study was inspired by the 2002 book Triumph of the Optimists. They plot the development of the world economy and financial markets since 1900.

Since then, US stocks have generated a compound annual return of 9.8%, while Treasury bonds have yielded 4.6%, short-dated bills have yielded 3.5%, and inflation has yielded 2.9%. For stocks and bonds, this results in an annual real return of 6.6% and 1.6%, respectively. Since 1960, emerging markets have also performed better, yielding an annual return of 10.9% compared to 9.6% for developed markets. All of the time charts extend comfortingly from bottom left to top right. Even in real life, setbacks are overcome, and each high point and low point is greater than the previous one.

The authors warn that "inflation has an important impact on long-term returns," with real returns peaking when inflation is at its lowest, particularly when economic growth is also higher. Since 1900, the real gold price has multiplied five times in dollars and twelve times in sterling, demonstrating that gold "has been effective at beating inflation over the long term." But aside from the 1970s bubble, which was virtually completely unwound by 2000, it was a bad investment for the first 100 years.

Investors with optimism still need to exercise caution.

The issue with drawing too much solace from the data is that while long-term investors may consider ten years, no one makes investments for a hundred years. It took over 21 years for the FTSE 100 to reach its peak of almost 7,000 on the eve of the new millennium; during that time, dividend income was generated, but real values were eroded by inflation. Wall Street and UK stocks both saw sideways trading from 1966 to 1982, and Wall Street did not return to its 1929 peak until 1954. According to the Stock Trader's Almanac, markets have a tendency to falter during inflationary times (like the 1960s and 1970s) and then soar back when inflation declined.

There are more issues than this. For the majority of the previous 126 years, investors were mostly restricted to their home market, making international investment a relatively new idea. Even "global" portfolios were typically 50% weighted to the UK until much later. Exchange controls persisted in the UK until 1979. The Yearbook notes that although the US makes up 62% of the MSCI All Country World index, its GDP share of developed markets peaked in 1950 at roughly 62%. Like China, which is at 23 percent, it is currently at 36 percent and gradually increasing. With almost 25% of the global stock market, the UK was the biggest in 1900. Russia trailed Germany by just 9 percent, while New York, at 16 percent, was barely ahead of France. In 1917 and 2022, the Russian market vanished.

Historian Niall Ferguson has demonstrated that, up until Austria's ultimatum to Serbia, investors were completely taken aback by World War I. The majority of bond and equity markets closed when the war broke out, some for years and others never to open again. He claims that by doing this, the biggest market crash in history was avoided. Country investors have been fortunate, while global investors have had to be agile.

Investing in the wrong stocks has been disastrous; sector and stock selection have also been important. Approximately 80% of the US companies listed in 1900 were in industries that are now small or nonexistent, such as railroads (the majority of them), textiles, coal, iron, and steel. In 1900, technology and healthcare, which now account for half of the market, were virtually nonexistent on stock exchanges. In 1900, railways made up almost half of the UK stock market, but their exposure to technology is still very limited.

Markets are driven by growth rather than shocks.

For optimistic investors, the lesson is that while you might be able to bury gold for a century, a stock portfolio cannot. The market fluctuates slowly, but over time, those fluctuations can add up to become significant. Investors should be wary of prolonged periods of high inflation, as there have been three since 1900, two of which have been linked to global conflicts. A return to the inflation of the late 1960s and 1970s is unlikely, but the extremely low inflation of a few years ago is most likely gone forever.

Geopolitical events have occurred periodically since 1900, but "economic risk has proved more significant," as the Yearbook demonstrates. Ed Yardeni, a market analyst, supports the idea by demonstrating that economic growth and earnings growth, rather than geopolitical shocks, are what drive markets. The limited impact of the most recent Gulf war on bond and equity markets has shocked and disappointed media pundits, who argue that marketsthat is, investorshave made a mistake.

However, markets are typically correct and pundits are incorrect, so it makes more sense to inquire as to why their analyses are flawed. This is not tough. Just thirty percent of the energy used fifty years ago is used for every unit of economic growth. Twenty percent of the world's oil passes through the Strait of Hormuz, according to pundits, but that figure includes oil that is being allowed to pass through to China and India. The pipeline from Iraq to the Mediterranean may be reopened, and Saudi Arabia has a significant pipeline to the Red Sea.

Above all, a period of rapid increases will result in a global surge in production and exploration. Prices for gas and oil have most likely already peaked and will drop precipitously in the coming years. It does not imply that the markets are complacent, but rather that there will be plenty of upside when an end to the conflict becomes apparent. The markets have been resilient on the downside and recovered sharply on any prospect of good news.