Credit crisis: Stocks and the long run

After the second 40% decline in America’s Standard & Poor’s composite index of common stocks in a decade, global investors are shell-shocked. Funds invested, and reinvested, in the S&P composite from 1998-2008 have yielded a real return of zero: the dividends earned on the portfolio have been just enough to offset inflation.

Not since 1982 has a decade passed at the end of which investors would have been better off had they placed their money in corporate or United States treasury bonds rather than in a diversified portfolio of stocks.

So investors are wondering: will future decades be like the past decade? If so, shouldn’t investments in equities be shunned? The answer is almost surely no. At a time horizon of a decade or two, the past performance of stocks and bonds is neither a reliable guarantee nor a good guide to future results.

Periods like 1998-2008, in which stocks do relatively badly, are preceded by periods, like 1978-88 and 1988-98, in which they do relatively well, and are in all likelihood followed by similar periods.

Do the math. At the moment, the yield-to-maturity of the 10-year US treasury bond is 3.76%. Subtract 2.5% for inflation, and you get a benchmark expected real return of 1.26%. Meanwhile, the earnings yield on the stocks that make up the S&P composite is fluctuating around 6%: that is how much money the corporations that underpin the stocks are making for their shareholders.

Some of that money will be paid out in dividends, some be used to buy back stock — thus concentrating the equity and raising the value of the stock that is not bought back. Some will be reinvested to boost the company’s capital stock.

You can argue that the corporate executives have expertise and knowledge that allows them to commit the funds they control to higher-return projects than are available in the stock market. Or you can argue that they are corrupt empire-builders who dissipate a portion of the shareholders’ money that they control.

The sensible guess is that these two factors cancel each other out. Thus, the expected fundamental real return on diversified US stock portfolios right now is in the range of 6% to 7%.

The expected market return is that amount plus or minus expected changes in valuation ratios: will stocks return more as price-earnings (P/E) ratios rise, or return less as PE ratios fall? Once again, the sensible guess is that these two factors more or less cancel each other out. Compare the 6% to 7% real return on stocks to a 1.25% real return on bonds.

Source: EconomicTimes