My thinking has changed a lot over the last few months. I began to get bullish last summer, just before Federal Reserve chairman Ben Bernanke announced the second round of the Fed’s quantitative-easing program. Stocks and other risky assets took off, driving the S&P 500 index up 30% to its April 29 high.
But since mid-April, I’ve become increasingly nervous and skeptical, because of seasonal factors and a lot of fundamental obstacles to the markets’ advance. (I wrote more about the "perfect storm" the markets face here.) I’ve followed my own advice and taken some money off the table, selling some of my stock mutual funds and ETFs. (I don’t own individual stocks.) And I don’t plan to put that money back in to the market, even after this week’s statements by Bernanke that he’d consider more monetary easing.
Obviously I’ve had a good run, and don’t want to push my luck. But more importantly, I’ve been looking at some research that defies the conventional wisdom that investors should keep a lot of stock in their portfolios even as they age, because only stocks protect investors against inflation and outliving their nest eggs. That concept — the need to hold a lot of stock at all stages of life — may be the single most wrongheaded idea in investing now. Retirees who took the advice of many financial planners had 60% to 70% of their assets in stocks when the financial crisis hit. Those who couldn’t hold on may have suffered irreparable losses.
And as Robert Powell of MarketWatch pointed out recently, selling stocks into a falling market — which far too many people did in 2008-09 — can create a cascading effect that reduces returns for years to come.
But I wanted to focus on the very premise that stocks necessarily outperform everything else over long periods of time, which should mitigate their risk. The evidence appears overwhelming. Stocks have thrashed bonds, Treasury bills, even gold since 1925, a period that included at least three major crashes and several big bear markets. That was the argument of Jeremy Siegel’s Stocks for the Long Run, probably the most influential investing book of this generation.
“The safest long-term investment has clearly been stocks, not bonds,” wrote Siegel, a professor of finance at The Wharton School of the University of Pennsylvania, who amassed data from two centuries of stock-market history to support his conclusions.
Recently, two professors launched a formidable challenge to Siegel. In a paper that has been circulating for a couple of years and will be published in the prestigious Journal of Finance, Lubos Pastor, a finance professor at the University of Chicago Booth School of Business, and Robert F. Stambaugh of Wharton say, in essence, that it just ain’t so: Stocks may be more volatile than we think, even in the long run, so investors shouldn’t own that much in their portfolios.
“There have been periods in which stocks underperformed [Treasury] bonds and bills over 30 years, [and] 40-year periods in which stocks barely [outperformed] bonds,” Pastor told me in an interview.
Pastor and Stambaugh’s argument is basically a statistical one. They say that the moderate volatility of stocks over long periods of time is a result of classic reversion to the mean. So, the long-term standard deviation of stock returns (a measure of variability) is 17% per year.
But they claim that when they use different statistical techniques that allow them to factor in uncertainty about average future returns, the resulting “forward-looking” measures of volatility produce a much higher annual standard deviation of 21%. That makes stocks nearly 25% more risky each year over any 30-year period.
You can read their paper here, but if you’re allergic to equations, I’d recommend a big dose of Claritin or Zyrtec first. (Just kidding.) Pastor also recently gave an enlightening interview on Consuelo Mack WealthTrack, which you can watch here.
Pastor goes even further, claiming that the 200 years of stock market data Siegel assembled, while impressive, is not nearly enough to make claims about future performance with any certitude. True, those 200 years had several depressions, two world wars (and several minor ones), a civil war, natural disasters, and many market panics. But they also spanned the rising fortunes of the United States, from a frontier market to an emerging power to the world’s leading superpower, to ... well, we don’t know what comes next. That’s the point.
He told me:
Even with 200 years of data, the US faces a lot of uncertainty. The past 200 years have been very kind to the US, [but] there’s some probability you might lose a war. There’s some probability you might have a financial meltdown. There’s no guarantee we’re going to bounce back [from them].
And indeed, America is struggling with a lot of problems: A broken jobs machine, rising competition from China and others, a fractious political system, and a looming debt crisis whose successful resolution is anything but certain. (Read more from me about the debt-ceiling quagmire at The Independent Agenda.)
That’s why he thinks returns from US equities may be lower in the future. “I do expect the average real stock-market return going forward to be lower than the historical average has been,” Pastor wrote me in a follow-up e-mail. “I wouldn’t be surprised if the 7% historical average real return were, say, 4% expected return plus 3% unexpected return, where the 3% represents good luck (a positive surprise).”
His personal opinion: Future average real return will be two to three percentage points lower than historical returns, which means he thinks stocks could return only 4% to 5% after inflation annually.
Which gets back to me and the rest of us. If Pastor is right, stocks will produce lower returns with more volatility in the future, potentially undermining the central argument for stocks in the long run. (Siegel didn’t respond to a request for comment, but you can find his views here.)
Pastor thinks investors should use Treasury inflation-protected securities to do the heavy lifting in beating inflation. They should ratchet down their equity allocation gradually as they approach retirement, and then keep it at that modest level for the rest of their lives.
Wealthier retirees can hold more stock, while those who are living from check to check should have almost none. But he thinks a 40% equity allocation is high, even though it’s much lower than that of many target-date funds offered by the big fund companies.
A study I did a couple of years ago showed a portfolio of one-third stocks, one-third bonds, and one-third cash had very little chance of running out of money until a person hit their 90s, given careful expense management.
I’m not thinking about retirement, but I am thinking hard about Pastor’s conclusions. That’s why I’ll keep a decent chunk of my portfolio in equities, but probably won’t put my recent profits back into the market.
It’s a very, very uncertain world out there, and all the rules are changing.