History Is Bunk? OK, More of Same From Stocks, Then
The 20th century now is history, and investors trying to build or preserve wealth in the new century may well be wondering if there’s any good reason to ever look back.
Has history stopped being relevant in terms of telling us much about making money in financial markets?
It would seem so in the case of stocks, as the most expensive issues according to classic valuation (price-to-earnings, etc.) just get more so, defying the financial laws of gravity.
Paying too much mind to history could have hurt you all through the ‘90s. At the start of the decade, conventional wisdom was that the spectacular performance of U.S. stocks in the ‘80s was justified as “catch-up” after the dismal ‘70s--but that we certainly couldn’t expect more of the same great returns in the ‘90s.
“Regression to the mean” was a popular concept around 1993 or so: The stock market, said many learned analysts, was about to settle into a period of weak performance that would pull the combined market return of the ‘80s and ‘90s back toward the historic average--something around 11% a year.
It was a nice, clean idea that seemed to make perfect sense. Except that the market had other ideas.
As it turned out, the ‘90s produced an even better return on blue-chip stocks than the ‘80s: 17.7% a year, on average, versus 17.6%, according to the most quoted authority on historic investment returns, Ibbotson Associates in Chicago.
(That 17.7% figure is through Nov. 30, and might inch up slightly given the market’s advance in December, but that’s just one month added on to 119 months in this case.)
The most bullish investors today will argue that much of financial history has indeed lost its relevance, and that there are good reasons to believe that the U.S. economy, and the stock market, have only open road ahead of them--and no silly speed limits to resurrect talk of regression to the mean.
*
That’s the basis for the rash of books proclaiming that the Dow Jones industrial average, which ended the century at a record 11,497.12, will have little trouble reaching 36,000, 40,000, even 100,000 within the next 20 years.
Soon, we can expect a similar crop of books focused on the technology-dominated Nasdaq composite index, which has become the new symbol of runaway bull market sentiment after its 85.6% surge in 1999, to end at 4,069.31.
Why should richly valued stocks stay that way, or get even more so? Look around, say the most optimistic of the optimists: We have a nearly all-capitalist world in which the United States is preeminent among economies; technology is changing everything, and is the primary force keeping competition high in every industry and subduing inflation (the destroyer of investment returns); and an aging post-World War II generation here and abroad must by necessity get, or stay, invested to build a decent retirement nest egg.
It’s impossible to argue with the first two of those points. On the final point, however, it’s worth remembering that while people may have to save or invest money, nobody can force them to put those dollars in stocks. There are alternatives.
The question is, could any of those alternatives truly compete with the stock market in the new decade and century?
Interestingly enough, while the super-bulls may suggest chucking history when attempting to judge the stock market’s potential in the years ahead, history in fact largely plays into their hands.
The accompanying chart shows the average annual returns on five major classes of investments since 1926, calculated by Ibbotson and compartmentalized by decade. Using decades is convenient, albeit contrived: The economic cycles that play such a big role in determining investment returns don’t abide by the calendar, of course.
Still, if you’re looking out two to three decades today in formulating an investment strategy, the returns over the last century at least give you a sense of what is possible in financial markets under varying economic scenarios.
*
Some market reactions are unlikely to change, even if this is a “new era” in other respects. Example: If inflation heats up--or the Federal Reserve believes it will--then market interest rates will surely rise further. That will be bad news for bonds, because older, lower-yielding bonds will automatically depreciate in value.
Anyone who owned bonds in 1999--and particularly bond mutual funds, whose share prices are calculated daily--knows all about depreciation.
In general, 20th century returns on bonds were never much to crow about. Only in one period--the 1930s--were bonds the best-performing of the five asset classes listed above. It took the Depression to make bonds a big winner, as people sought safety amid deflation.
Are bonds really competition for stocks, then? Not over long periods, barring another Depression. Still, because bonds pay interest, there is an element of capital preservation there for people (mainly older folks) who need that.
But note: In six of the eight periods in the chart above, the average annualized total return on intermediate-term Treasury bonds either exceeded or was very close to the return on long-term Treasury bonds.
Long-term bonds generally are those maturing in 10 years or more. Intermediate-term bonds are those maturing in three to 10 years. Usually, the longer a bond’s term, the higher the annual interest yield paid.
But the risk you face to get that higher yield is much greater volatility in the value of long-term bonds than in intermediate-term issues. As market interest rates rise, it makes sense that a 20-year bond paying a fixed lower yield will decline in value more sharply than will a 3-year bond, because another investor would have to factor in the risk of 20 years of sub-par yields instead of just three years.
What the returns of the last century suggest, simply, is that anyone who wants to own bonds ought to just stick with intermediate-term issues.
Another lesson of the century: Money market securities, in the chart above represented by 30-day Treasury bills, never reigned as the best-performing asset in any decade.
That’s what we would expect from standard financial theory: A virtually risk-free investment shouldn’t be a high-return investment as well. Money funds will never be a ticket to substantial wealth generation.
Which brings us back to stocks. As the chart shows, in every decade but the ‘30s, either big stocks (those in the Standard & Poor’s 500 index) or smaller stocks (in this example, the smaller tier of New York Stock Exchange issues) racked up the best returns of the five asset classes shown.
Coincidence? Hardly. Whether they are temporarily overpriced or not doesn’t change the underlying appeal of stocks: They offer the simplest way to profit from the economy’s expansion. Despite the inevitable recessions and bear markets in our future, if your long-term outlook for the U.S. economy is optimistic, 75 years of data say you have to be in stocks.
Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.
