Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 543

Stocks don't always beat bonds

Until recently, the expected long-term total return for equities seemed obvious. Since 1871, U.S. stocks had outgained inflation by an annualized 6.9%. When Wharton professor Jeremy Siegel extended that analysis to 1802, the result barely altered, registering 6.7%. That figure closely resembled the average stock market gain of 20 non-U.S. countries during the 20th century.

Thus, equities figured to earn 6% to 7% per year, after inflation. The evidence urged the conclusion. While stocks are of course highly risky in the short term, over time their returns were, to cite Siegel’s phrase, “remarkably durable.”

That premise of persistent 6%-plus stock market returns, when measured over long periods, has since been threatened. Additional work from the international-stock investigators trimmed their estimate to an annualized 4.3%. And in “Stocks for the Long Run? Sometimes Yes, Sometimes No,” which scrubbed and updated the U.S. equities database, Edward McQuarrie of Santa Clara University cut the pre-World War II estimate for real equity performance to 5.4%. That essentially matched what bonds had delivered.

As detailed in McQuarrie’s paper—and summarized in my article—the combination of lower stock market returns and somewhat higher bond market totals (which have also been revised because of further research) scotched the assumption that equities invariably outgain fixed-income securities. Before World War II, stocks managed that feat on only about half the rolling 30-year periods.

McQuarrie’s objection

Should you care? McQuarrie believes so. As he points out, the advice to hold stocks for the long run, as popularized by Professor Siegel, relies heavily on the “stationarity” of equity returns. The logic supporting that advice was:

  1. It is true that the future will not repeat the past.
  2. It is also true that investment conditions evolve. Industries come and go, as do government policies, interest rates, and corporate profitability.
  3. However, knowing that things will be different in the future is not particularly helpful, because profiting from that realization requires that one predict how things will differ. Good luck with that.
  4. Consequently, the best forecast for future events is what already occurred. The more stable the historical results, the more reliable that estimate.
  5. Because long-term real stock market returns, across both time and countries, have been extremely stable, the expectation that over several decades they will earn a real return of at least 6% annualized, while also beating bonds, is quite sensible.

McQuarrie’s paper undermines that argument by challenging the stationarity presumption. When examining both the full U.S. record and the experience of other countries, he maintains, equities do not outperform so consistently. The apparent norm is, in fact, a case of modern American exceptionalism.

The revised history

For McQuarrie, U.S. investment history consists of three stages:

Three investment cycles
(U.S. Markets, McQuarrie's Formulation)


Source. Edward McQuarrie.

Initially, equities and bonds traded wins. Equities then triumphed spectacularly and unprecedentedly for four decades, before the horse race once again resumed. (Strictly speaking, equities have also outdone bonds during the third period, but the contest has been much closer than during the previous decades.)

The counterargument

The rebuttal to this interpretation comes naturally. The affairs of other nations are only moderately relevant to this country. What happened when buggy whips were popular, even less so. A reader amusingly phrases the latter contention:

“New data reveals that mortality rates for leg amputations from 1793 to 1920 far exceed what was previously reported. Therefore, we should adjust the expected mortality rate for leg amputations going forward. Some may ask, ‘Have not advancements in medical knowledge, equipment, medicines, and hygiene greatly reduced the risk of dying after surgery?’” Not, however, the data collectors.

Obviously, his contention is technically incorrect. McQuarrie certainly has contemplated such issues—but has been unconvinced. After all, some aspects of human existence have changed less than others. Modern medicine, transportation, and communications far exceed Alexander Hamilton’s experience. On the other hand, Mr. Hamilton would immediately almost understand today’s courtrooms and political discussions.

Which side Is correct?

The debate about the utility of the additional investment data is therefore practical rather than theoretical. Some 19th-century experiences remain pertinent, while others have become outdated by either technology or custom. What about stock and bond market performances? Where do they rate in that framework?

On that issue, the academic community and investment professionals tend to diverge. When projecting future investment returns, both parties extrapolate from the past. In that, they are alike. Where they differ is with data selection and adjustments. For most finance professors, forecasts are best conducted with as much data as possible and as little tinkering. In contrast, investment professionals tend to pick their spots. When sifting through the history, judgment is required.

My sympathies land somewhere in the middle. On the one hand, American investment markets have indeed hugely changed. The 19th century was a cesspool of stock price manipulation, fraudulent offerings, and investment panics. What’s more, the Federal Reserve system had not yet been created. Consequently, bad times all too frequently became worse owing to the lack of a lender of last resort.

That said, as even the dissenting reader granted, McQuarrie’s evidence is wonderfully useful for challenging complacency. By historical standards, modern American equity returns have been exceptional. They are unmatched within this country’s history, and with few equals outside it as well. There are many reasons for their success, and many intelligent and thoughtful observers who believe that such prosperity—give or take—can continue. (Warren Buffett, for one.)

But the optimists could be wrong. The case for the ongoing dominance of stock is less overwhelming than we once believed. That observation bears consideration, especially for retirees tempted by advice that they invest heavily in equities. Such counsel is not necessarily wrong, depending upon individual circumstances (in particular, wealth levels), but it often is coupled with the implicit assumption that stocks will inevitably beat bonds over the long term.

Maybe. If not, though, retirees do not get a second bite at the financial apple. That lesson is very much worth pondering.

Note: When I sent Professor McQuarrie the reader’s comment, he forwarded me the following response:

“My take is in the article’s title. Sometimes stock returns will soar far above bond returns, as after the war. That outperformance can be sustained for decades. Other times stocks will lag bonds, for decades. There’s no rhyme or reason to it, and in all likelihood, no predictability over the individual investor’s limited time horizon of several decades.

“As for your reader’s clever riposte, here is my redo: ‘The rate of death from disease and epidemics stayed at a relatively high and constant level from 1793 to 1920. Then advances in modern medicine fundamentally and permanently altered the trajectory ... or so it seemed until COVID-19 hit in February 2020.’”

 

John Rekenthaler has been researching the fund industry since 1988. He is a columnist for Morningstar.com and a member of Morningstar's Investment Research Department. The views of the Rekenthaler Report are his own. This article is general information and does not consider the circumstances of any investor. Originally published by Morningstar and edited slightly to suit an Australian audience.


Try Morningstar Premium for free


 

RELATED ARTICLES

Where to put your money these days

Which asset classes are undervalued right now?

Time to announce the X-factor for 2023

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.