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Financial planning, Investment and Self Managed Super Fund Article
Equity Market Volatility
By John Robertson
1st November 2006
This article may be out of date.
Bolstered by a rejuvenated macroeconomic environment, the Australian equity market has become less risky.
Historical returns from the Australian equity market have been relatively attractive. One indicator of this can be seen in the work of Elroy Dimson, Paul March and Mike Staunton reported in their book Triumph of the Optimists: 101 years of Global Investment Returns (Princeton University Press, 2002).
In that work, the authors were able to identify only three out of sixteen countries that had never experienced any shortfall in real returns over a twenty year period. One of these was Australia.
Their analysis, summarised in the first chart, ranked Australia’s real equity return at the top of the 16 countries studied, with relatively low volatility.
Australia’s annualised real return from equities, according to the study, was 7.5% compared with a global median return of 4.9%.
One of the more important points to come from the Dimson et al analysis was that investors in North America, Australia and, to a lesser extent, the UK are likely to have a biased view of potential investment returns since the Anglo-American market experience has not been typical of global equity returns.
A broader range of equity market experiences suggests that returns and market volatility are likely to be less attractive than the Anglo-American markets alone might suggest.
Dimson et al concluded that the best equity market performances had come from “resource rich countries such as Sweden, Australia, South Africa, the United States and Canada”. Their reference to the best performing markets being in resource rich countries is especially pertinent for Australia presently.
The common perception of resources related equities is that they add too much investment risk. Although returns from resource investments can be relatively high, the additional return has not always been sufficient to compensate adequately for the additional risk which comes with such stocks.
A history of volatility
Australia’s relatively better performance was primarily a pre-1950s phenomenon.
Over more recent times, namely since 1958, the average pre-dividend nominal return from the All Ordinaries index until 2000 and the ASX 200 subsequently has been 7.4%. This raw return was still better than in the US market where, over the same period, rolling 12 month returns for the S&P 500 index averaged 6.9%.
However, the distribution of returns does modify some of the conclusions which can be drawn about relative investment attractiveness. The blue bars in the second chart represent the returns from the Australian market; the yellow line shows returns using the US market indicator. The Australian market had a slightly higher proportion of negative returns over this period of time (32% compared with 28%).
The Australian market was also more prone to above average returns with a higher frequency in the right hand tail of the return distribution.
Put another way, the Australian market has been more volatile than the US market.
Since, on average, Australian interest rates have also been higher than in the US, the risk adjusted excess return for the Australian market has been inferior to the comparable return in the US.
The average Australian 10 year bond yield has been 1½ percentage points higher than the average US 10 year yield since 1958 and there has been a similar 1¼ percentage point spread in cash rates.
Exchange rate risk would also have been a factor in coming to a judgment about the attractiveness of the Australian market.
The exchange rate has been especially important for Australian market valuations because of Australia’s dependence on foreign capital to compensate for its low saving rate.
In the 30 years since 1970, while funds management was becoming increasingly globalised and Australian companies becoming more dependent on offshore money managers for their funding, the Australian dollar declined at an average rate of 2.3% a year against the US dollar, eroding some of the positive investment returns for an offshore investor.
A new macroeconomic environment
Since the early 1990s, the trend to a lower exchange rate has been halted as Australian inflation has been brought into line with international inflation rates; interest rates have fallen; and the volatility in Australian growth has been reduced.
At the same time, several key microeconomic reforms gave Australia a more competitive economy.
The abandonment of a central wage fixing system and reduced protection for import competing industries meant individual companies had to become more self-reliant and adept at adjusting to changes in their external environments, helping to make the Australian economy less prone to periods of lengthy adjustment after suffering unexpected shocks.
Forcing companies to meet competition caused some to fail, but the remainder showed improved and more consistent financial returns.
Less volatility now
Not surprisingly, against this background, the volatility of the Australian market has also declined noticeably. The third chart shows a five year rolling standard deviation of annual returns for both Australia and the US calculated by thebigpicture Economics. The timing of rises and falls in market volatility tends to reflect changing macroeconomic conditions.
Given the nature of international economic linkages, many of the turning points in market volatility in Australia and the US have coincided.
In the early 1960s, at the very beginning of the period shown in the chart, there was little difference in market volatility between the two, but throughout the 1970s and 1980s, Australia was the more risky of the two markets.
This coincided with the worst of the Australian economic experience culminating in Treasurer Keating’s references to Australia becoming a banana republic and, later, “the recession Australia had to have”.
The chart shows a clear-cut reduction in market volatility in the aftermath of these dramatic events, beginning in the early 1990s and continuing to the beginning of the new century.
Toward the end of this time, US macroeconomic conditions were also changing and, aggravated by the September 2001 attacks on the World Trade Centre, market volatility there was on the rise.
Since 2002, and for the first time in over 40 years, Australia has appeared the less risky of the two markets.
Since late 2002, Australian market volatility has been rising. In part, this might have been due to it falling to unsustainably low levels in the late 1990s, but the timing of the change coincides with the onset of a new commodity price cycle and upturn in related equity prices.
Even so, Australian market volatility has remained below that of the US market, one of the continuing benefits from the fundamental changes to its economic performance.
This should mean, in the Australian market context, that every dollar of Australian company profit is valued more highly now than would have been the case in, say, 1990 before these changes had taken effect.
It should not come as any surprise, therefore, when equity market analysts present comparisons of international equity prices showing that Australian equities have been revalued and are trading more in line with stocks in other markets and above their (1970s to 1990s) historical averages.
As Dimson et al have shown, this is a turn towards a performance level that, many have forgotten, was once more the norm for Australia rather than strange behaviour to be treated sceptically.
*John Robertson is proprietor of thebigpicture Economics and publisher of thebigpicture – guideposts for the private investor. John can be contacted at firstname.lastname@example.org or on 03 9500 8391.
John Robertson is also a member of the investment committee of the Emerging Resources Company Share Fund (http://www.eimcapital.com.au/ercsf.htm) and may be involved in investment decisions relating to companies mentioned in this article.
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