Personal Finance: The danger of being too bullish

Anyone who writes about stock markets on a regular basis is, as I remarked last week, liable to make mistakes. Error comes with the territory, and multiplies exponentially the further forward you look.

Some mistakes, however, are more egregious than others: my apologies therefore for the inadvertent statement in my column last week that the long-run real rate of return from the stock market has been 67 per cent per annum. Would it were so! The actual figure, of course, and the one I originally put in the column, before the gremlins struck, is 6 per cent to 7 per cent - and a very nice figure it is too, especially when compounded over a number of years. Nothing else in investment, as we know, beats the stock market for long-term capital appreciation.

Nothing alters the fact, either, that averages are averages and when they are exceeded consistently, they have to be followed by periods of less than average performance. Looking back on the year in the markets in 1997, we should be grateful for the fact that, while nearly all the market forecasters got the London and New York markets wrong, they all at least erred on the right side - by underestimating what a good year it proved to be all round.

As the chart shows, it was a year when shares (as measured by the All Share index) produced a total real return of 23.6 per cent. (Total real return measures the combined return from dividends and capital appreciation, after allowing for the extent to which inflation has eroded the purchasing power of your investment.) This, to put it in context, is the 10th time in the past 16 years that the All Share index has produced a real return in excess of 20 per cent per annum.

Last year might have been a good one for the All Share index, but there have been six others which have been even better since 1980! Given that there have been only two years during the last 18 (1990 and 1994) when the All Share index has actually fallen, it is evident that we are living through a bull market of quite remarkable length and intensity.

The average real total return from the All Share index since 1980, according to BZW, has been 19.4 per cent - that is almost three times the long-run historical average.

The record in the United States has been just as good. Given that many investors have never experienced a full-blown bear market, it is perhaps not surprising that the average mutual fund investor in the United States believes, according to consumer surveys, that putting his money into the stock market is likely to produce an average capital gain of 30 per cent not just next year, but every year into the future!

History and simple arithmetic, alas, tells us that this simply is not feasible - though it also tells us that there is nothing wrong in enjoying the good times while they last.

Just don't, for prudence's sake, assume that they will last for ever. Like me, you are probably no great fan of insurance companies and have more than a little difficulty in understanding how the bonuses on your endowment and other policies are calculated. But the fact that many of the bigger providers are now cutting their annual reversionary bonuses, while paying out large and still handsome terminal bonuses, is not a surprise. They are right to warn that the exceptional market returns of the past 15 years are highly unlikely to persist for the next 15 years. In fact, I would go so far as to say that you would be unwise to invest with one which pretended otherwise.

Looking at the chart also shows two other things of interest. One is the now widely observed phenomenon that the stock market gains were not evenly distributed across the range of publicly quoted companies. The biggest companies, as measured by the FTSE 100 index, comfortably outperformed their medium and smaller company brethren in the FTSE 250 and small capitalisation indices, as they have done for most of the 1990s.

The so-called small cap revival which is always expected to materialise in the later stages of a bull market has yet to appear, though it will probably do so eventually.

The other feature to note is the strong performance of gilts. They may have been overshadowed by the exceptional performance of the stock market, but I am happy to say (having ventured to praise their merits on several occasions) that 1997 was also a quite excellent year for gilts too. Real returns of 19.3 per cent for long-dated gilts, 11.3 per cent for shorter maturities and 10.8 per cent on index-linked made it one of the best years in recent memory: only 1982 and 1993 produced clearly higher real returns. Even though, in practice, the stock market has done better in the past 12 months, I stick to my view that, adjusting for risk, someone faced with the choice between the two classes of asset a year ago would have been better advised to go for the safer gilts option.

Gilts also did well on an international comparison. They produced the highest returns of any of the large bond markets (including the United States, Germany, Japan and France). The election of a user-friendly Labour Government, and its prompt decision to hand over monetary policy to an independent Bank of England, was a crucial factor in underpinning the already favourable economic and inflation environment.

While short-term interest rates are rising, longer-term interest rates are still on a downward trend - in part reflecting the view that the new monetary policy arrangements are doing their job at ensuring that inflation does not rear its head again in the future (hence also the exceptional performance of index-linked gilts).

Is the gilts party over yet? Without wishing to predict another year as good as last year's, I have to say that I rather doubt it. Many of the fundamental arguments for gilts still look attractive, and the current financial crisis in the Far East hardly counts against them the worse it gets, the bigger the impact on the rest of the world, and the likelier it is that bond yields will fall.

Despite their strong recent performance, UK bond yields are still the highest of any country in Europe: although we are committed to staying out of the first wave of European monetary union, there are reasons to expect that our bond yields will continue to converge with those that are signing up for that high-risk enterprise. And while short-term inflationary pressures are clearly rising, I cannot for the moment see any real clouds on the longer-term horizon. My only worry is that many institutional investors seem to be thinking the same way - and one prefers not, in this business, to be part of a consensus view, since the one thing we do know is that consensus expectations, like consensus forecasts, never come true.