Evanson Asset Management - Stocks for the Long Run?

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Stocks for the Long Run?

(Updated August 2007)

"Stocks for the Long Run." This belief is pretty much investment gospel and is repeated incessantly in the financial media. Simply invest in stocks, and let the market bail you out over the long run. And, in the world of passive and index investing, buy and hold is quintessential. Dr. Jeremy Siegel, Professor of finance at Wharton, and author of the very popular book, "Stocks for the Long Run" (1998), presents a thorough analysis of stock market data showing that stocks returned about 7% above inflation for the past two hundred years, and that for twenty year time frames, stocks outperformed bonds over 90% of the time.

But, very long-term statistics often conceal problems which may arise for investors with portfolios heavily allocated to stocks. This paper will briefly examine historical data and argue for caution in uncritically accepting the hypothesis that stocks are always the best investment for the long-run.

(1) The long run can turn out to be extraordinarily long, far longer than an investor's investment horizon.

If an investor entered the market last century when the Dow was one-standard deviation above its long-term trend line, an exuberant bull market top, how long did they have to wait? Leuthold (InvestmentNews, 5/21/2001) notes that an investor at the peak in 1929 took until August, 1998, almost 69 years, to reach a nominal return of 10% on their money, including dividends. This is an after inflation yearly return of about 7%. Thus, it took 69 years for an investor to reach the long-term average return for stocks, and had an investor in 1929 relied upon long-term stock returns data to calculate their future net worth or retirement income, they would have been sorely disappointed.

In addition, from its peak in 1929, our long-term investor had to endure an 86% decline in the value of his portfolio to its low in July, 1932. The Dow Industrials holds some of America's largest and financially soundest companies, and cannot be considered an aggressive or speculative part of the stock market. Yet, investors choosing this relatively conservative sector of the stock market would have had to have extraordinary nerves, and an abundance of decades to see a long-term average return on their investment. This is far more than can be realistically expected.

(2) Real returns differ substantially depending upon time of market entry, and for the typical investor with a twenty or twenty-five year time-frame, this can make very large differences in money available during retirement. Frequently presented "mountain" charts smooth out and conceal what would have happened to unfortunate investors who happened to enter the market at or near long-term secular bull market peaks.

An investor in the S & P 500 from 1929 through 1949 received an inflation adjusted return of 4.54%. Yet, an investor beginning in 1932, and holding until 1951, received an inflation adjusted annual return of 10.84%, over 6% greater per year. Our 1929 investor received a compound total return of 84.36% for twenty years; our 1932 investor received a compound total return of 818.13% for twenty years, and ended up with almost ten times as much as our unfortunate 1929 investor. Extend the holding period out to twenty-five years, and our 1929 investor does better, receiving a compound total return of 319.33%, but our lucky investor still receives far more, 2202%.

Let's compare returns for the last big market top and bottom. An investor in 1968, a market top, had to wait until 1983, fourteen years to just breakeven after inflation. If they waited until 1987, twenty years, their annual return was 4.19% after inflation, and their compound total return was 489.24%. If they waited until 1992, twenty-five years, their annual return was 5.83%, compounded to1132%. Today's big bull market began in the early 1980's, so only twenty years or so data is available at this point if we consider the 2000-2002 sell-off as a correction. But, an investor in the market from 1981 through 2000 received a whopping after inflation return of 12.91% annually, and a compound total return of 1741%; it was the best twenty years in U.S. market history. Yet, an investor in Japan at its peak in 1989 still has not recovered to breakeven 17 years later in 2007. Japanese residential real estate and equities are still down around 60%. Time of market entry matters yet there's not evidence markets can be timed.

In 1997, Peter L. Bernstein, author of several popular and well-respected books on investing, cautioned investors about employing the long run as a benchmark because the long run is not a homogeneous state of the world, a smooth and straight line into the future. A very large portion of the vaunted equity returns over the riskfree return, the equity risk premium, is accounted for by just 32 years out of 200 years since 1800, 1950-1981. Bonds outperformed stocks 43% of the time, and stocks were superior over the very long run, but with a high degree of uncertainty during periods of time shorter than 150 years. He concludes that, "...the long run can tell us perilously little about what kinds of environments lie ahead...we have to accept uncertainty."

Easterling, E. in "Unexpected Returns: Understanding Secular Stock Market Cycles" examines secular bull and bear markets and how they interrelate with p/e ratios, dividends, GDP growth and inflation. Historically, secular bull markets have run as long as 24 years (1942-1965) and as short as 4 (1933-1936). On average, they lasted 13.5 years. Secular bear markets have averaged 11.3 years and have ranged from 4 years (1929-1932) to 20 years (1901-1920). Easterling found that for 85 twenty year periods starting in 1919, twenty years being a reasonable investment time horizon for most people, starting p/e's were strongly correlated with forward returns. When p/e's were19 or higher, forward 20 year nominal returns ranged from 1.5-4.5%. When p/e's averaged 10, forward returns averaged 11.9-15.0%. Interestingly, bear markets exhibited much higher volatility than bull markets. His data clearly indicate that high 20 year returns occur when p/e's are low, dividends are high (over 5% vs. under 2% a/o 2007), inflation is moving towards stability, and interest rates are moving solidly lower, not conditions in place as of 2007.

It's very clear from the above analyses that luck or chance in the form of time of market entry plays a major role in the returns most investors can expect to receive from stocks. Enter at or near a market bottom and you may receive 6 to 8% or more per year than the investor who enters at a market top, and your compound returns may be up to ten times greater than that of an investor who enters at a market top. These are huge differences. Enter at a market top, and you may have to live through a 65% or greater decline, and receive only a breakeven return for more than a decade, sometimes two. And, to make matters worse, there is no evidence that anyone can accurately time big market tops or bottoms or know for certain where we are in long secular cycles.

(3) Although extensive research indicates that the stock market cannot be accurately timed (Sherden, The Fortune Sellers, 1998), as noted above there is persuasive evidence that high stock valuations based upon traditional measures of value eventually leads to low future returns. Robert Shiller (Irrational Exuberance, 2000) looked at twenty year returns following market peaks in price/earnings ratios, and found inflation adjusted annual returns averaged -0.2% to +1.9%. Smithers and Wright (Valuing Wall Street, 2000) looked at historical data on the Q-ratio, similar to market-to-book value but based upon replacement costs. The Q-ratio has an even better record predicting future market returns than p/e's or dividend yields. They found that bull market peaks in Q have produced later declines in prices from 50% to 80%. As of Spring 2004, the Smither's group estimated that the U.S. stock market was 60% overvalued based upon Q. From then until mid-2007, market prices rose around 35%.

Fama and French (private paper, 2000) and Asness (Bubble Logic, 2000), looked at other valuation measures, including dividend payouts and the so-called Fed model, and reached similar conclusions about future equity premiums and returns. On August 21, 2001, the Wall Street Journal reported that, based on earnings as reported under GAAP, the S & P 500 actually finished the prior week with a p/e ratio of 36.7, higher than any other p/e previously recorded for the index, well above the 1929 peak, and 2.5 times the average historical p/e. As of Summer, 2001, most methods for calculating market valuations showed them higher than they've ever been except for the prior few years. As of July 20, 2002, even after a severe sell-off in the S & P, the p/e ratio for the S & P 500, as measure by trailing 12/bottom line net earnings, not projected operating earnings, was 34:1. As of May, 2003, excessively high valuations persisted, with the S & P at 33:1. As of August 2007, p/e's were at 18:1, still very high by historical standards but the quality and durability of earnings are probably more questionable than they've ever been. In 2006 for the first time more corporate cash flow was devoted to stock buybacks than any other corporate expense, 51%. By mid-2007 corporations were borrowing more money per month in the debt markets than ever before, again devoting the money largely to stock buybacks. Stock buybacks drive up earnings per share numbers as stocks are retired and also drive up stock prices. In addition, aggregate p/e's today for the S&P 500 and other indexes are reported with negative earnings removed, driving up "e's" and driving down p/e's. Today's "e" is also somewhat clouded by creative accounting procedures and the tendency to report net operating earnings or proforma earnings, not true net earnings. Bear market lows, the most likely to provide high forward returns, occur when p/e's are 10 or under and p/e's as of mid-2007 do not bode well for future long-term equity returns though keep in mind that this has been the case for several years and equity markets are up strongly.

(4) Long-term global data offers a less sanguine view of equity returns than U.S. data. Shiller argues that the U.S. was the most economically successful nation in history from 1900 through 1999. Therefore, recent U.S. returns data almost certainly exaggerate potential returns, and the United States in the twentieth century may have been been the exception rather than the rule in terms of real returns for stocks. Jorion and Goetzmann (J. of Finance, 54[3], 1999) studied inflation adjusted stock market appreciation, excluding dividends, for thirty-nine countries for the period of 1926-1999, and found that the median real appreciation rate was only 0.8% per year compared to 4.3% per year for the U.S. The favorable social, economic, technological, and military conditions that lead to past high U.S. returns may not repeat themselves in the future.

Long-term U.S. stock market data, beginning in 1802, show that stocks did much better relative to bonds in the twentieth century than in the nineteenth. Bonds outperformed stocks from 1802-1839. Since there have been five 40 year periods in the last 200 years, this data suggests that the odds that bonds will beat stocks for a 40 year period are roughly one in five, 20%, low, but not insignificant.

"Triumph of the Optimists", published in Spring 2002 by Dimson, Marsh, and Staunton, reviews the equity risk premium for 16 countries from 1900 through 2001. It is the most ambitious study of financial market returns done to date. Aggregate global returns suggest that there is about a 17% chance that equities will underperform short-term government bills for a 50 year period at a standard deviation of 23% and about a 25% chance for a 40 year period. They conclude, "There is clearly a substantial probability of achieving a negative risk premium, even over long investment horizons...equity investment is not that compelling as a short or intermediate term strategy." Forty or fifty years is not what most investors are thinking when they are thinking "long run". The Wall Street Journal (2-10-03) offered further insights into long-term risks in Dimson's latest update on global investment returns. Out of 16 major national stock markets, investors from only five would have been guaranteed positive annual returns over every 20-yr period during the last century.

Truman Clarke of DFA (Spring 2003) examined the probabilities that U.S. stocks will beat T-bills over various holding periods. He employed a statistical procedure called bootstrapping to create 10,000 simulated histories of one through twenty-five year periods based upon data from 76 years of returns on three U.S. equity asset classes. For a twenty-five year period, the probabilities ranged from 82.4% to 96.2%, certainly not the sure thing that most of Wall Street promotes, though better than the 101 year global equity data from Dimson, et al.

What can an investor conclude from the studies presented above? Do not buy the "Stocks for the Long Run" hypothesis uncritically. It is based upon the presentation of very long-term returns data, and may not reflect what a real investor will experience in the market over reasonable investment time frames in the future. It most definitely underemphasizes the pain and disappointing returns stock investors may suffer if they happen to enter the market at the wrong time. Wall Street and the money management industry have a vested interest in moving investors into stocks because they get paid more for buying and managing stock portfolios than for bond portfolios or cash. Wise investors should look at both sides of the risk/return picture and adjust their equity/fixed ratios accordingly.

Investors must be also be very careful about assuming past long-term returns will repeat within twenty or twenty-five year periods, particularly if they are dealing with lump-sum or retirement monies. If that's the case, increasing allocations to bonds is one way of controlling the downside risk. Older investors in markets with high valuations may not live long enough to enjoy the benefits of stock investing, or may even outlive their principal if a serious bear occurs. Younger investors who contribute yearly have an opportunity to buy when markets are down, and more time, which makes it likely, but not certain, that they will outlast bad bears.

Lump sum and retirement investors should also be cautious when using programs which purport to calculate how much money will accumulate for retirement, and how much can be withdrawn safely each year during retirement. These programs are nearly meaningless if they use linear compounding calculations, the most common approach, and are a bit better if they use Monte Carlo probability estimates. But even Monte Carlo simulations depend upon past data and certain assumptions programmed into the calculators. We cannot know future inflation rates, tax rates, and returns on equities or fixed income.

In sum, the prudent investor should look closely at risk and return data, worst returns data hidden in long-term statistics, and critically evaluate whether the widely accepted belief that stocks are always the best long-term investment fits their particular circumstances and temperament.

steven@evansonasset.com