Too early to extol the long-term virtues of stocks

Among the distorted truths masquerading as wisdom is that stocks always deliver positive real returns over long periods and outperform government bonds

THE MONTH of June has drawn to a close and not before time, as the turmoil in stock markets has seen most investors register negative returns during the year’s first half, compounding the losses that were incurred during the latter half of 2007. Those experts who typically advocate the advantages of active investing and market timing are now instead extolling the long-term virtues of stocks.

Unfortunately, many of these same investors now have the dubious record of failing to match the rate of inflation over the past 10 years as the emergence of a savage bear market in 2000 alongside the current turbulence has seen real returns, the only sort that matter, drop into negative territory. Those who have entrusted their monies to the so-called experts may wish to ask: how long is the long term?

Investors’ mindset appears to have been shaped by the great bull market from 1982 to 2000, which witnessed the greatest increase in total real stock returns in US financial history.

This extraordinary period saw investors adopt a host of half-truths and untruths as conventional wisdom. The list of distorted truths is endless, but perhaps the most costly has been the mantra that stocks always deliver positive real returns over long periods and always produce superior performance to government bonds.

Such beliefs have ensured that institutional investors are almost always overweight in stocks and vulnerable to a market downturn.

Investors who have examined returns over longer periods have also been hoodwinked into believing the incredible. Prof Jeremy Siegel of Wharton demonstrated in his best-selling book, Stocks for the Long Run, that equities have generated a real annual rate of return of almost 7 per cent over long periods with remarkable consistency.

Furthermore, he showed that the variability of stock returns over extended periods has been less than that of government bonds. The ill-conceived conclusion is that stocks are the safest asset for long-term investors.

The consistency of stock returns and the resulting decline in the variability of returns over long periods at a more rapid pace than that implied by standard mathematics is clear evidence that stock returns are mean-reverting. In other words, bad periods follow good periods, just as night follows day. Indeed, the US stock market has endured seven primary bear cycles since 1802 and is currently eight years into another. The typical duration of a structural bear market is 14 years and the annualised real return over all seven completed down cycles has been close to zero. This compares to an annualised real return of more than 13 per cent over the seven completed up cycles.

The past century has seen three primary bull cycles: 1921–29, 1949–66 and 1982–2000. Each up cycle was heralded as a “new era” and saw investors apply rich valuation multiples to elevated earnings.

Widespread belief that the business cycle had been repealed was evident towards the end of each secular bull market, which allowed for a reduction in the risk premium attached to stocks. So too was the conviction that high earnings growth could persist indefinitely.

Most bizarrely, in each instance, investors expected high returns to continue, even though higher growth rates had already been reflected in stock prices while a reduction in the risk premium called for lower returns going forward. Needless to say, each “new era” ended badly.

The first “new era” ended in 1929, as destructive deflation ensued and crushed corporate profits. Stock prices lost almost 85 per cent of their value by the time the stock market bottomed in the summer of 1932, returning to the nominal levels that prevailed in 1898. It took more than a quarter of a century for the major indices to register a new high in real terms.

The second bull market ended in the late 1960s as runaway inflation contributed to a sharp increase in economic volatility. Stock prices declined almost 40 per cent from late 1969 to the end of 1974, returning to the levels that existed in 1963. In real terms, the damage was far more brutal as stock prices lost almost two-thirds of their value and did not bottom until the summer of 1982.

In real terms, stock prices were no higher at the low in 1982 than in 1954 and it took a further 10 years for equities to surpass the levels first reached in the late 1960s.

The end of the greatest bull market in US financial history eight years ago has seen real stock prices drop by roughly 30 per cent in the intervening period and in real terms have returned to levels first seen towards the end of 1997.

The damage has been less severe than that incurred in previous bear cycles, but with trend earnings of roughly $60 a share, the market still looks expensive versus history on 22 times – ie an earnings yield or expected long-term annualised real return of 4.5 per cent. However, the yield available on 10-year treasury inflation-indexed notes, the appropriate benchmark for long-term investors, is currently below 2 per cent, which means that stocks are offering an incremental annualised return of roughly 2.75 per cent.

The risk premium currently available on stocks is no longer outrageously low, though it is still far from the attractive levels that have defined the end of structural bear cycles. Furthermore, should the variability of returns over the next decade be identical to that observed historically, there is still a better than 30 per cent probability that stocks will fail to outpace the risk-free asset. A return to the heady days of the late 1990s remains a long way off and consequently, it is still too soon to extol the long-term virtues of stocks.

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