Alas, the first decade of the 21st century proved a great disappointment. There were two big equity downturns, in 2000-02 and 2007-08; the average pension plan in the OECD achieved a miserly return of just 0.1% a year.


In a new book* Thomas Aubrey, a credit analyst, argues that investors have been led astray by the belief that economic growth drives asset-market returns. Not only is it difficult to forecast the economy, studies show there is little relationship between GDP growth and equity returns. First, many quoted companies are multinationals. Second, economic growth is often accompanied by new equity issuance, so the full benefits of growth do not accrue to existing shareholders. And third, it is quite possible for profits to rise much more rapidly when GDP is sluggish, as has indeed been the case in recent years.


Instead, investors should focus on the credit cycle. The idea derives from Knut Wicksell, a Swedish economist, whose book “Interest and Prices” was published way back in 1898. The basic concept, later taken up by the Austrian economic school, is as follows. When things are in equilibrium, the return on capital (the profits of businesses) should equal the cost of capital (their borrowing costs). If the return on capital is higher than the cost, there will be great demand for credit and an economic boom will ensue. If the return on capital is lower than the cost, there will be a slump as companies go out of business.


Mr Aubrey adds the observation that, although businesses know their funding costs, they cannot know their future return on capital. As a result, “entrepreneurs are continually surprised by the differences between actual returns compared with expected returns, which is the cause of the dynamic nature of the economy.”


This analysis prompts him to suggest that investors should monitor the difference between the return and cost of capital, a figure he dubs “the Wicksellian differential”. Should the gap be positive and growing, equity prices will rise and the economy will take on more debt. If the gap is falling, equity prices will decline.


The tricky bit lies in estimating these two numbers. Mr Aubrey uses the return on the corporate sector’s invested capital (both debt and equity) for the return on capital, and the five-year moving average of five-year government-bond yields for the cost of capital. This second measure is hardly ideal: even in times of fiscal crisis few companies can borrow as cheaply as the government. But it is the change in trend that matters, and the government-bond yield is at least a consistent measure.


Mr Aubrey backtested his model between 1986 and 2011, switching into equities when the gap was widening and into government bonds when it was narrowing. The approach would have earned an 8.7% average real return from American assets between 1986 and 2011, more than either equities or bonds would have earned on their own.


This outperformance occurred even though the model would have switched investors into government bonds from 1996 to 1999, missing the dotcom boom. The model performed far better in the recent crisis, switching investors into government bonds in 2007 and 2008 and back into equities in time for the strong stockmarket rally of 2009 and 2010.


At this point, a note of caution is needed. Analyse the data for long enough and it will always be possible to find a model that, in the past, would have delivered outsize returns. All too often, however, such models fail to perform when investors try to use them in practice. For the current year Mr Aubrey says his model favours American equities; the British market is less promising.


Even if that turns out to be wrong, at least he is looking in the right direction. His thesis echoes “Manias, Panics and Crashes”, the classic study of bubbles by Charles Kindleberger, which suggested that “the cycle of manias and panics results from the procyclical changes in the supply of credit” as optimistic businesses and consumers take on more debt during booms, only for banks to stop lending in the busts. Anyone who read Kindleberger’s book in 1978 was at least forewarned about the past two decades.



* “Profiting From Monetary Policy: Investing through the Business Cycle”. Palgrave Macmillan, 2012