New York Stock Exchange, 11 Wall Street, New York.

The Barclays Equity Gilt Study 2009, which examines the long-term returns on a variety of assets, calls the past 10 years a "lost decade" for shares, where "equities have been the worst performing asset class since 1997, sharply underperforming all other asset classes." The report says"in nominal terms, the -0.3% annualised return from US equities since 1998 is the fourth-worst 10-year return of the past 83 years. Only those 10-year periods ending in 1937, 1938 and 1939 have delivered lower returns. Similarly, over the past 109 years, only the decade ending in 1974 saw a weaker 10-year nominal return from UK equities. For the sake of record, the 1964-74 UK equity return was 1.02%, while the 1998-2008 return was 1.05%."

The last consecutive decade in which stocks produced a lower real return than Treasuries, was 1967-77 in the US and 1927-37 in the UK.

Barclays says during the past 110 years, there have been some 16, 10-year periods that bear resemblance to the decade just past and like in the past decade in which investors who prudently re-invested their dividends lost money after inflation - each time, they made money in the next ten years, by an average of almost 11% a year even after factoring in rising prices.

Western companies have entered the current recession in their worst financial shape of the entire post war period, the report has warned.

Despite a perception that the current crisis is focused on financials and other businesses over-exposed to gearing, the level of debt accumulated and the extent of its substitution for capital investment has created systemic liabilities, said Tim Bond, the report’s lead author.

"In recent years, the non-financial sector has spent considerable sums – more than $2 trillion since the end of 2001 – on purchasing equities," he said. "Indeed, by the fourth quarter of 2007, companies were spending more on equity purchases than capital investment."

"Regardless of the multiplicity of causes, the macroeconomic impact is clear. The substitution of debt for equity inevitably weakens the creditworthiness of the corporate sector. The fact of the matter is that the recent boom in debt-equity substitution has left the corporate structure in its worst shape – from a credit perspective – of the entire post war period. From both perspectives, the trend will therefore be of relevance to the banking sector’s willingness to lend to businesses," Tim Bond added.

He said, that demographic trends across both the US and Western Europe supported a gradual reversion toward higher yields following the lost decade of the late 1990s onwards.

Looking at the number of baby boomers approaching retirement and entering their peak saving years, he said that the curve exactly coincided with US peak equity valuations.

Bond says in the report, that the investment industry pays enormous attention to forecasting corporate profits and the economic cycle, but very little to aggregate valuations.  The study shows, conclusively, that where you begin from in valuation terms, is by far the most important factor influencing subsequent equity returns. 

The report, shows that the 1995-2008 overvaluation of equities was the most extreme in stock market history, and that, in the past, once equity valuation measures retreated from a period of overvaluation, they always moved to a period of substantial undervaluation, sometimes lasting several years.

Simply, equities may stay cheap for many more years.

The Barclays study also looks at the long-term prospects for different asset classes.

If  the world’s resources continue to be consumed at an unsustainable rate, there will be resource-based inflation, probably combined with lower growth and greater volatility in the economic cycle.

The report says the China effect is crucial. In contrast to the shock increase in the world’s labour supply, which for some years proved disinflationary, the acceleration in per capita incomes points the other way. It produces a multiplier effect on consumption of raw materials.

For China and India to reach US levels of oil consumption per head would be literally impossible, since it would involve at least a trebling of global production. And if their copper consumption were to equal that of developed Asian economies, known reserves would be gone in a decade.

The report says there will be a hoovering up of investment by resource sectors generally, including water, waste disposal and alternative energy. In such a world, diversified portfolios may no longer make sense. In the 1970s, resource-based portfolios were alone in producing real returns. In future, industries such as autos and airlines will be gradually squeezed out by competition for funds from the resource sectors.

Meanwhile, equities in general will suffer from the higher risk premium due to economic instability, and bonds from higher inflation. Debt leverage will go into reverse, so the price of housing and other assets will fall. The banks will find basic lending much less profitable and will have to diversify.

In addition, there are likely to be fewer asset bubbles.

To obtain a hardcopy of the Equity Gilt Study, email equitygiltstudy@barclayscapital.com

Alternatively purchase the study.

Synopsis

Chapter 1 – The lost decade
Equity investors have been on a wild and ultimately disappointing ride over the past decade. Equities have been the worst-performing asset class since 1997, sharply underperforming all other asset classes. We examine the causes of this relative weakness, and find that the utility of simple valuation measures has been thoroughly vindicated by the dreadful recent returns from equities. We show how future long-term returns from equities – the equity risk premium – can be forecast. We also describe the factors that cause equity valuations to fluctuate over time. Finally, we compare the outlook for stock and bond returns over the next 10 years.