Yesterday's piece strongly suggested that the performance edge of stocks over bonds could erode in the years ahead. My intent was to present contrarian thinking that might lead you to reconsider the assumptions underlying your investment stance. I promised a follow-up on the investment implications of that analysis.
Before we do that, though, let's recap briefly.
Robert Arnott, managing partner at
, an investment advisory service based in Pasadena, Calif., and Ronald Ryan, president of
, a pension consulting firm based in New York, presented a paper on Monday arguing that bonds could outperform stocks in the coming decades. (The paper is slated to appear in the winter issue of the
Journal of Portfolio Management
.) Arnott said he expects stocks to earn only a 3% to 4% average annual real return, significantly below the 5% to 7% real return assumptions suggested by historical data.
Now, you can certainly argue with some of the assumptions used by Arnott and Ryan to estimate stocks' future return. They use, for instance, the market's recent 1.2% dividend yield, which is pretty much the historical low. Use a higher figure -- let's double the assumption to 2.4%, which is closer to the longer term average -- and the future return on stocks would look 1.2 percentage points better.
They assume real dividend growth will be 2%, which is twice what it has been over the past 74 years. If you are a "New Economy" believer who thinks we may see real GDP growth above 5% per year, it's difficult to see dividend growth north of 3% a year. If you split the difference and assume dividend growth of, say, 3%, you do add another 1% to the estimated return on stocks. If you make these two adjustments, Arnott and Ryan's estimated return figures jump from 3.2% a year to 4.8%.
However, 4.8% is still a country mile behind the 8.4% real return stocks have achieved for investors over the past 74 years. And if you subtract from that 4.8% figure today's 4.1% inflation-adjusted U.S. Treasury bond yield, the estimated edge for stocks over bonds going forward is only 0.7%. This is a far cry from the 5.1% lead stocks maintained over bonds in the 1925-1999 period.
My takeaway: Even when you use more liberal assumptions than Arnott and Ryan, stocks may well have less of an edge over bonds for the foreseeable future. And a world of lower absolute or relative returns to stocks would have some pretty important investing implications, according to Arnott and Ryan. They may be advising institutional investors overseeing mainly nontaxable pension accounts, but there are lessons for the rest of us.
First off, if you are 100% in stocks, consider increased diversification. Yes, stocks have outperformed bonds over the past 74 years, and by a far wider margin over the past 18 years of the bull market. Yes, it has paid to be 100% long stocks. But as Arnott and Ryan write: "Extrapolating the past is one of the most common and dangerous ways to forecast the future. Past is not prologue. In fact, there is a modest but significant negative correlation between long-term past returns and subsequent future long-term real returns."
Along these lines, Arnott noted that in the early 1990s one of the most popular asset categories among investors was guaranteed investment contracts (GICs). People sought the high yields of GICs at a time of relative weakness in stocks. GICs, of course, went on to be one of the worst performing investments of this decade. In contrast, stocks, especially technology stocks, did the best. By the beginning of this year, of course, we saw many folks buying nothing but tech at nosebleed prices. "Where is the wisdom in that?" asked Arnott on Monday.
Arnott and Ryan suggest diversification into a number of alternate investments.
Arnott says that he owns Treasury Inflation Protected Securities (TIPS). He likes
TIPS because they are "a government-insured 'risk-free' real return vehicle that not only could beat stocks over the next 20 years, but probably
." (Note that he owns TIPS on a leveraged basis to goose his returns.)
He also said he found commodities, many of which have until recently been in long-term bear markets, "very interesting." This squares with my thinking that oil and especially natural gas stocks may still be in the early stages of a multiyear bull market.
Arnott cautioned against rushing into venture capital and private equity (what we used to know in the bad old '80s as leveraged buyouts). Why? They require buoyant stock markets to flip the private deals to the public. Given the tumult going on in both the high-yield bond market and large parts of the stock market, that may be more difficult to do anytime soon.
What about overseas stocks? Arnott had no especially strong views. He did say, however, that those markets, according to his and Ryan's analysis, are not especially less risky -- i.e., volatile -- than the U.S. market.
Perhaps the most profound implication of the Arnott and Ryan thesis is that passive index investing may not be as successful in the future as it has been in the recent past. Until this year, you could simply buy the
S&P 500 stock index or the
Nasdaq Composite stock index and achieve superior returns because you had a remarkable wind at your back.
But perhaps no more, according to Arnott and Ryan. They say that "active management," which I take to mean picking stocks, may once again offer investors an edge.
Stock picking. Now there's a wild idea.