Death of Equities: Part of a Never Ending Series

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Includes: DIA, QQQ, SPY
by: Eddy Elfenbein
John Authers had an interesting article in yesterday’s Financial Times. In it, he questions the received wisdom of investing in stocks for long-term financial planning.

This is a serious question because even if stocks are the best long-term investment, and I believe they are, the fact is that it takes longer than people realize to see the benefits. The cream rises to the top but it can take an awfully long time. Stocks had a miserable period from the mid-60s to the early-80s, and the last nine years haven’t been much fun either.

It seems pretty unreasonable to tell folks to have patience when the time frame needed can be half a person’s pre-retirement planning. Authers writes:

Further, recent experience challenges that basis of modern finance, the 'efficient markets hypothesis', which in its strongest form holds that prices of securities always reflect all known information. This implies that stocks will react to each new piece of information, yet without following any set trend – a description that cannot be applied to the events of the past 18 months. On these foundations, theorists worked out ways to measure risk, to put a price on options and other derivatives and to maximise returns for a given level of risk.

This theory also showed that stocks would outperform in the long run. Stocks are riskier than asset classes such as government bonds (which have a state guarantee), corporate bonds (which have a superior claim on a company’s resources) or cash. So the argument was that those who invested in them would in the long run be paid for taking this risk by receiving a higher return. That is now in question.

Unfortunately, Authers errs here by confusing EMH for CAPM which was developed by William Sharp (and others) in the 1960s.

Stocks should outperform bonds over the long haul simply because of the nature of the two asset classes. A bond is a loan and therefore implies that lender and borrower both believe that the borrower can get a better ROE than the interest rate charged on the loan. Not surprisingly, this is why stocks have beaten corporate bonds.

While government bonds have won the race over the past decades, Felix Salmon rightly points out that we’re currently looking at a T-bond bubble and a trough for stocks.

Jonathan Clements reiterates the long-term case for stocks:

Over the past 60 years, gross domestic product has climbed 6.8% a year—and shares prices have climbed 7%, as measured by the Standard & Poor’s 500-stock index. On top of that 7% a year, investors also collected dividends.

True, share prices didn’t climb in lockstep with the economy and, indeed, investors had to suffer through some horrendous bear markets. Still, as long as the economy continues to grow over the long haul, the stock market should remain a decent long-run investment.

Felix adds: “I suspect the pendulum is going to swing back on that front, which means that stock-price growth could lag GDP growth indefinitely.” That could certainly happen for a little while, but I have to object to the word indefinitely. If the stock market were to trail GDP indefinitely well...there wouldn’t be anymore stock market. Why bother using the public markets to raise funds? There would be no point.

The premium of stocks over long-term corporate is real albeit small and highly volatile. The lesson is that investors should always have a sizable portion of their assets in fixed income.