Secrets of Success: The expert's grim predictions on shares

Actuaries did not get the most ringing endorsement in the interim report on the profession by Sir Derek Morris, commissioned by the Treasury and published just before Christmas. The profession was criticised for being too insular and too slow to absorb the fact that the investment climate was changing more rapidly in the 1990s than conventional wisdom had it. It is hard to disagree with that conclusion, though whether some of the reforms now being mooted will produce a better result is an open question.

Actuaries did not get the most ringing endorsement in the interim report on the profession by Sir Derek Morris, commissioned by the Treasury and published just before Christmas. The profession was criticised for being too insular and too slow to absorb the fact that the investment climate was changing more rapidly in the 1990s than conventional wisdom had it. It is hard to disagree with that conclusion, though whether some of the reforms now being mooted will produce a better result is an open question.

That said, my experience has been that the best actuaries are perfectly capable of providing conscientious and realistic advice on the behaviour of financial markets - at least, once freed of the burden of conflicts of interest imposed by doing fee work for participants in those markets. A good case in point, as some readers may recall, came in the autumn of 2000, when Professor David Wilkie of Heriot-Watt University, Edinburgh, gave a powerful demonstration, in a presentation to a European conference, of the kind of insightful modelling that a good actuary can provide.

The former partner of Watson Wyatt delivered a then still startling warning that the remarkable equity market returns experienced in the UK for the previous 18 years could not and would not be sustained. His confident forecast, based on an analytical model he himself developed, was that equities were expensive and inevitably heading for a substantial fall over the coming 10 years.

I reported his findings in the belief that such realism, which was in stark contrast to the still unqualified optimisim of the broking and fund management industry, might be of some value to private investors. Four-and-a-half years later, after three years of a savage bear market in equities and a partial recovery, it seemed like a good moment to revisit Wilkie and find out whether he thinks the worst of the decline in shares is now behind us. At my request, he has helpfully re-run his model in order to update his projections.

The results are interesting, though not necessarily comforting. In his original presentation, he pointed out the fact that while the bull market of the 1980s had been underpinned by substantial increases in real (that is, inflation-adjusted) dividends from the corporate sector, its continuation in the 1990s was almost entirely driven by a general re-rating of share prices. That is, it was driven by perceptions, rather than further improvements in fundamentals. The re-rating trend was illustrated by decline in the market's dividend yield from 5.85 per cent at the start of the 1980s to an all-time low of 2.42 per cent at its end. Wilkie provided similar assessments for the US and German stock markets.

The results, he concluded, demonstrated that prospects for positive share-price returns over the succeeding 10 years were slim to non-existent. There was little scope for further improvements in ratings, as valuations were already as good as they could get, and little prospect that the underlying drivers of earnings and dividends could support any real growth in share prices. His conclusion was that, out of equities, bonds and cash, cash was as likely as any other to be the best home for investors over the 2000-2010 period.

He calculated that the potential decline in share prices needed to restore the stock market to an equilibrium valuation level (defined as a return to its 1990 dividend yield, and assuming unchanged inflation) was the equivalent of an annual rate of return of minus 5.5 per cent in Germany, minus 6 per cent in the UK, and minus 9 per cent in the US.

The implication of these numbers was that the market needed to fall by at least half in the UK just to get back to where it had started the 1990s. In practice, using his model, he thought the outcome would be less drastic than this over the whole period 2000-2010, but would still result in a substantial loss of ground by equities versus bonds and (especially) cash.

That looks now like a sagacious market call. In his re-run of the model, he has been taking stock once more. Since 2000, the UK market's dividend yield has crept up from 2.4 per cent to between 3.2 and 3.5 per cent. That provides some fresh underpinning to share prices but, as yet, nothing like enough to make shares look attractive as an asset class in the medium term.

Two messages stand out from Wilkie's analysis. The first is that, in order to return to the 1990 equilibrium level by 2010, despite the bear market, share prices still need to fall substantially - by 5.4 per cent per annum in the UK, and by 10.8 per cent per annum in the US. This, if you like, is a measure of how far above trend equity markets still are.

The second, mildly more comforting, message is that, according to Wilkie's model, the actual out-turn over the remainder of this decade may prove a little better than this. His central projection is that UK shares might experience some modest real dividend growth over the rest of this decade, while share prices remain broadly flat. US shares, on the other hand, he thinks may still have to fall by an average of 3.9 per cent per annum, and German shares by as much as 8 per cent per annum. (These are central projections, the most likely of a range of outcomes, not specific forecasts.) "My conclusion," says Wilkie "is that shares, particularly in the US and Germany, but also in the UK, are unlikely to give a good return in the next few years."

jd@intelligent-investor.co.uk. A summary of Professor Wilkie's latest findings can be found on my website, www.intelligent-investor.co.uk.