Nasdaq Vs. Safe Investments

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by: Scott Sumner

This is a follow up to my recent post on the tech bubble.

In my view, 3-month T-bills are the best asset for estimating nominal risk-free returns that can be earned at various moments in time. During some periods of US history, it's possible to earn very large nominal risk-free returns (real plus inflation). During other periods, nominal risk-free returns are depressed by a variety of factors. During these challenging periods, other investments may or may not struggle to earn high nominal returns. Usually they will struggle. (Consider 1929-45).

Nonetheless, it seems reasonable to compare the performance of other investments to this risk-free benchmark. If you don't see why, read my previous post, especially the example of why the 30-year Treasury bonds yielding 15% in 1981 was misleading. (A commenter pointed out that those interest payments could not be reinvested at 15%, but it was still a pretty impressive nominal investment, ex post.)

Unfortunately, I don't know how to find the figures I am looking for, but I'll present my estimates, and then let commenters who work in finance correct my numbers:

1. A series of investments in 3-month T-bills from the end of 1999: Roughly a 35% to 38% total nominal return. (Based on a quick look.)

2. Investing in Nasdaq at the end of 1999 (at 4069), then reinvesting dividends: Roughly a 121% total return.

3. Investing in Nasdaq at the absolute peak in March 2000 (at 5048), then reinvesting dividends: Roughly a 78% total nominal return.

My point is not that those Nasdaq returns are all that impressive (especially if you were unlucky enough to buy at the absolute peak), but rather that these returns were earned in a very challenging investment climate, where risk-free returns were quite low.

It's not obvious to me that the difference between 121% and 37% isn't enough to compensate investors for the extra risk from Nasdaq stocks compared to long-term investments into a series of T-bills. As I mentioned earlier, the excess returns earned by stocks from 1926 to 2000 were probably excessive, in retrospect, even accounting for risk.

Here's how I'd put it. In 2002, the consensus view was that 2000 had obviously been a bubble, and that Nasdaq stocks were obviously grossly overpriced at that time. Given what we know today, a fair-minded observer would say that Nasdaq stocks may have been overpriced in 1999-2000, but it's no longer a slam-dunk that an extreme bubble ever existed.

PS. I tried to find total returns on Nasdaq, but could only find them for the past 10 years. During that period, 10,000 invested in Nasdaq, with dividends reinvested, rose to 36646. But the index itself (ignoring dividends) rose by a smaller amount. Thus 10,000 invested 10 years ago would now be 32750, if you ignore dividends. The total return figure of 36,646 is about 11.9% higher than the simple increase in the index, over the past 10 years.

So it seems reasonable that over 18 years the total return figure (including dividends) is about 20% higher. Thus you'd want to calculate total returns as if Nasdaq were about 9000 today (not 7500) relative to investments back at the end of 1999. Does that make sense? That's how I got my estimate of total returns.

Of course, real returns would be lower, but they'd be equally lower for any alternative investments (such as T-bills), so it would be a waste of time to work with real variables, even if the inflation numbers were not unreliable.

PS. Why don't our history books call July 2002 to April 2003 a "negative bubble" for Nasdaq? It ranged from 1100 to 1500. More importantly, why isn't there even a word for negative bubbles?

PPS. Even more importantly, why isn't there even a word for big plunges in NGDP growth?

Happy 4th of July to my American readers.