The main driver of long-term equity returns is capital (or price) appreciation. Equities tend to outperform other asset classes during periods of strong economic growth, and they tend to underperform other asset classes during weaker economic periods.
Capital (or price) appreciation of equities often occurs when investing in companies with growth in earnings, cash flows, and/or revenues—as well as in companies with competitive success.
The most common sources of income for an equity portfolio are dividends. Companies may choose to distribute internally generated cash flows as common dividends rather than reinvest the cash flows in projects, particularly when suitable projects do not exist or available projects have a high cost of equity or a low probability of future value creation.
Dividends have comprised a significant component of long-term total returns for equity investors. Over shorter periods of time, however, the proportion of equity returns from dividends (reflected as dividend yield) can vary considerably relative to capital gains or losses
Equity securities offer diversification benefits due to less than perfect (i.e., less than +1.0) correlation with other asset classes.
It is important to note that correlations are not constant over time. During a long historical period, the correlation of returns between two asset classes may be low, but in any given period, the correlation can differ from the long term.
Exhibit 3. Correlation Matrix, January 2001 to February 2017
- Empirical evidence suggests equity provides long run protection against inflation.
- And equity is a claim on real earnings power and company assets.
- However that does not hold in all time periods and countries.
- In the short run and in a hyperinflationary environment, often do not provide a hedge and have negative correlation with inflation.
Certain empirical studies have indeed shown that real returns on equities and inflation have positive correlation over the long-term, thus in theory forming a hedge. However, the degree of correlation typically varies by country and is dependent on the time period assessed. In fact, for severe inflationary periods, some studies have shown that real returns on equities and inflation have been negatively correlated.
When assessing the relationship between equity returns and inflation, investors should be aware that inflation is typically a lagging indicator of the business cycle, while equity prices are often a leading indicator.