Are Stocks a Good Buy?

(MoneyWatch)  The forecasts I've seen recently seem to predict stocks will return about 7 percent, well below the long-term return of just under 10 percent. The forecast of a 7 percent return basically comes the following:

• A current dividend yield of about 2 percent
• Real growth in earnings of about 2.5 percent
• A forecast of inflation of about 2.5 percent

Given such a forecast, many are asking if the risks of equity investing are worth the relatively low forecasted return. Let's see if we can provide some perspective to help answer the question. We begin by looking at the history of returns. The table below shows the returns for the period 1926-2009.

	Annualized Returns (%)	Real Return (%)
S&P 500 Index	9.8	6.8
Five-Year Treasury	5.3	2.3
20-Year Treasury	5.4	2.4
Inflation	3.0	n/a

Over the last 84 years, the S&P 500 has provided a 4.5 percent higher return than five-year Treasuries and 4.4 percent higher return than 20-year Treasuries. Today's forecast of a 7 percent return for equities is 2.8 percent less than the historical return. Using the aforementioned inflation forecast of 2.5 percent, we get a forecast of real returns to stocks of about 4.5 percent.

Now let's consider the forecast for returns on Treasuries. The current yield is the best forecast of the return on bonds. Today, the yield on five-year and 20-year Treasuries is about 2.1 percent and 4.1 percent, respectively. Given the forecast of inflation of 2.5 percent, the expected real returns are -0.4 percent and 1.6 percent, respectively. Thus, stocks are forecasted to have a real return 4.9 percent and 2.9 percent, respectively, above the expected returns on Treasury bonds.

The 4.9 percent difference between the expected real return on stocks and the real return on five-year Treasuries is actually 0.4 percent above the long-term differential. From that perspective, stocks look attractive relative to bonds.

The 2.9 percent difference between the expected real return on stocks and the real return on 20-year Treasuries of 2.9 percent is 1.6 percent below the historical average. But even that doesn't necessarily make stocks a poor investment -- there's still a 2.9 percent per year difference in expected returns as compensation for the incremental risks of equities. If you have a long horizon, an incremental return of almost 3 percent per year produces a huge difference in wealth creation when you consider compounding.

So, when we consider stocks versus intermediate bonds, we actually have the expected real return on stocks above the long-term differential. For longer-term bonds, the difference is below the long-term results, but there's still a sizeable premium. Also, if you purchase longer-term bonds, you take on the added risk of unexpected inflation.

The bottom line is that while the expected nominal return to stocks is lower than the historical return, so is the expected return to Treasury bonds. You should decide if the expected risk premium for stocks is sufficient given your unique ability, willingness and need to take risk. A Monte Carlo simulator can help you make the decision.

To summarize, the fact that the equity risk premium is below the historic average is basically irrelevant to the decision. What matters is the size of the premium relative to your ability, willingness and need to take risk.