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Are Stocks Really Doomed?

The September issue of The Atlantic Magazine has an article called The Great Stock Myth. The writer makes the pitch that stock returns may never reach previous years' levels. What I find most amusing about such articles, which I read only because they provide a never-ending supply of fodder for my blog, is that they always seem to appear after periods of poor equity performance.

Let's discuss some of the problems with The Atlantic article. The main problem is that while investors should expect that there will be an equity risk premium (ERP), they should also know that stocks are risky no matter what the horizon. The fact that there have been long periods of negative returns only demonstrates that stocks are risky. In other words, the ERP should always exist in an ex-ante sense, though not always in an ex-post sense. If that weren't the case, there would be no risk, and investors would price equities to have the same return as Treasuries.

The right way to think about ex-ante forecasts of returns is as follows. The mistake that many investors make is that they treat expected returns as deterministic, as opposed to probabilistic. By that I mean that the expected return should be viewed as only the median forecast. So, let's assume that you expect a 7 percent return. But, you really should think of it as a 50 percent chance of more or less than that, and, say, a 40 percent chance of more than 8 percent, 20 percent chance of more than 9 percent, etc. And the same thing is true on the other side -- meaning there's, say, a 10 percent chance of earning less than 3 percent, a 5 percent chance of losing money, etc.

The next problem with the article is that it states that the ERP has eroded. To check this, you should consider valuations. The historical average price-to-earnings ratio is about 16, and the current P/E ratio is below 20. In early 2000, it was well above 40. It's also important to remember that the market is forward-looking, and the expected full year earnings of the S&P 500 is about $80. With the S&P 500 currently at around 1,060, that would put the P/E ratio at less than 14 (below the historic average), and we're only about three months from the end of the year.

There is yet another problem. The article states: "Modern diversified portfolios have reduced some of the risk of holding stocks, because even if a few companies fail, they won't take your entire nest egg with them. Rather, the failures average out with the successes to produce a relatively steady rate of return." Nowhere in Modern Portfolio Theory does it say anything about failures averaging out with successes to produce a relatively steady rate of return. This is sheer nonsense. In fact, it's been known for decades that stock returns exhibit high volatility, skewness and excess kurtosis.

Another factually incorrect statement is the following: "As defined-benefit plans -- what your grandfather called a pension -- have died off, people have poured their retirement savings into mutual funds that offer this sort of diversification. The deeper pool of money flowing into equity markets means that equities no longer need to offer a higher yield in order to attract money from bond and other securities markets." The idea that stocks had to offer higher yields than bonds disappeared from the literature about 60 years ago when investors began to understand that stocks must have higher expected returns, not higher yields.

The reason stock returns (using the S&P 500 as proxy for stocks) have produced low returns since 2000 has nothing to do with any of the arguments made in the article. The S&P 500 was basically doomed to provide low returns over the last decade because the ERP had shrunk dramatically by 2000, as P/E ratios climbed to over 40 as a result of the irrational exuberance of the 1990s. High P/E ratios are correlated with low future returns, and vice versa. To illustrate the point further, after adjusting for inflation that has averaged about 2.5 percent a year since 2000, earnings of the S&P 500 are about unchanged from where they were in 2000, yet stock prices are still below the level of 10 years ago because the P/E ratio fell by more than half.

We know that individuals invest as if they were driving through rear view mirrors -- they buy after periods of high returns and sell after periods of low returns. The financial media tends to do the same thing, writing articles about the death of equities after periods of poor performance, and vice versa. While we're certainly not advocating that one should use the press as contrary indicators, we're saying that most of what you read from the popular financial media should be treated as what Jane Bryant Quinn called investment porn.

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