Understandably, equity investors are taking nothing on trust. Any investors who kept “buying the dips” paid a heavy price during the past three years, and equities are now treated with great suspicion. Even contrarian investors have lost their courage, as it is rare to find anyone who is outright bullish towards the market.

The poor performance of stocks means that the ratio of equity returns to bond returns (long-run Treasurys) is now back to its level of early 1980. In other words, a buy-and-hold investor would have done just as well holding Treasurys as investing in the S&P 500 during the past 23 years. Of course, one could have outperformed in stocks by successfully timing the cycles, but that is difficult to do on a sustained basis.

A long-run chart of the stock-to-bond ratio challenges the view that stocks have been the superior investment over the long run (See Chart I-5). The stock-bond total return ratio did not show any net change between 1969 and 1979, as well as between 1980 and 2003. Wall Street’s dirty secret is that in the 34 years since February 1969, stocks outperformed long-term Treasurys by a paltry 1% a year, on average. That is a dismally small gap given the extra volatility in stocks. Moreover, the equity outperformance over that period all occurred in a short period between late 1979 and late 1980, when bonds were crushed by the Fed’s new high-interest rate policy.

The only true golden periods for stocks during the past 80 years or so were the 1950s and 1960s. That was when stocks persistently outperformed bonds, with only occasional short-lived reversals. This “golden era” of equity outperformance began when equities were very cheap: the S&P 500 was trading at 7 times trailing reported earnings in 1950. Meanwhile, bonds were expensive because the long-term Treasury yield was pegged at around 2%, far below the underlying rate of inflation.

By the end of the 1960s, the economic environment had begun to deteriorate and neither stocks nor bonds offered particularly good value. In the 1970s, both assets performed poorly, with inflation-adjusted total returns of minus 2½% a year (See table). By the start of the 1980s, stocks and bonds were cheap again. Both enjoyed a powerful bull market during the next two decades with real returns averaging 8.3% a year.

Table I-1
Long-Run Market Returns

Looking ahead, stocks should outperform bonds during the coming decade - although not by a huge margin. Treasurys are now expensive while stocks are close to fair value. If we assume an unchanged price-earnings ratio, then equities should achieve total returns of about 7½% a year (6% earnings growth, plus a dividend yield of around 1½%). Bonds will deliver less than that, given that yields are more likely to rise than fall from current levels. Stocks would outperform Treasurys even if the price-earnings ratio (based on operating earnings) declined to its historical average of 14 over the next decade. However, as in the past, any additional returns from stocks will be small relative to the extra risk.

The above analysis explains why we are not optimistic about equities on a long-run basis. Even if the secular bear market has ended—and that is a debatable point—stocks will not provide much in the way of excess returns for many years to come. This is fully consistent with the behavior of other assets after a bubble has burst. The classic profile is for the market to trade sideways for an extended period (Chart I-6). However, this does not rule out occasional cyclical rallies that create good trading opportunities.

Chart I-5


Chart I-6

Reprinted with permission from The Bank Credit Analyst, March 3, 2002