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  • Return Assumptions and the Bear

    Posted by Carl from Chicago on February 14th, 2008 (All posts by )

    A lot of people throw around terms and assumptions without questioning them deeply. One of the most common assumptions is that stocks beat bonds (and beat the heck out of cash) “over the long haul”.

    The basis in fact for this assumption is the long term equity records in the USA, the UK and Canada. These markets, over the long haul, have provided returns beyond bonds and cash.

    Why only these markets? Because the rest of the markets (Germany, Japan, China, etc…) had some sort of cataclysmic event (World War, hyperinflation, or takeover by non-capitalist regimes) that make comparisons “over the long haul” useless. Even in these markets it is hard to see how wealth could have been preserved; cash (currency) was debased and debts were reneged upon, so all bets were off.

    One key element of the “returns beat bonds and cash” is the assumption that you stay the course through horrendous market periods, hold on to equities, and then ride the upward ticks. If you act as many people do and sell when the market gets difficult, you are apt to be out of the market when it shoots upwards. Some of these bear markets are very lengthy and you have to have nerves of steel to ride them out.

    I bought a recent book (in paperback) called “Hedge Hogging” by Barton Biggs explaining how he ran a hedge fund and all that goes with it. Mr. Biggs has been in the markets for a long time, and he started out right as the Bear market of the 60’s and 70’s occurred. From the book:

    “I launched Fairfield Partners on June 1, 1965, with $9.7M, $200,000 of which was mine. The Dow Jones Industrial average closed on May 30, 1965 at 912. SIXTEEN YEARS LATER it was at the same level. By 1981 adjusted for inflation , the DOW had lost more than half of its 1965 purchasing power value, even when you added back the dividends that you had been paid.”

    In parallel, there was an article in Barron’s on January 21, 2008 titled “Looking Back at the Lost Decade”. Per the article, here is the annualized total return from 12/31/99 through 12/31/07 by asset class:

    – 30 year Treasuries 8.77%
    – 10 year Treasuries 6.45%
    – Dow Jones Industrials 3.95%
    – Cash 3.24%
    – S&P 500 Index 1.66%
    – Nasdaq -4.7%

    Since the beginning of the year the S&P 500 has lost another 5.5% or so… a bit more of this would drive the total return for the decade so far into negative territory (and it is punishing the NASDAQ, too).

    Remember, this is average total return over the period… for stocks to catch up to bonds (or cash, if current performance is factored in), they’d need a pretty good long run of performance.

    The third leg of the post are those recent advertisements I have seen on TV where the guy is considering retirement or whether to keep working. After he thinks about it for a while, he talks to his broker who says “Yes” meaning that he has enough money to retire.

    The sentiment of those commercials was echoed in a recent article in the WSJ titled “Be Skeptical of the Hard Sell, Even if it is in the Workplace”. The article describes a 52 year old woman who retired after 33 years as a secretary at Eastman Kodac based on advice from the retirement counselors, Morgan Stanley, who were referred to by her employer.

    The conflicts of interest in this area are immense. First of all, the employer often wants the older and more expensive employees to leave, since their rate / hour is higher and they drive up insurance costs. Of course, the employer can’t admit this, since it is illegal, but all things equal.

    To say that the broker has a conflict of interest is an even bigger understatement. If you don’t retire, the broker makes nothing. If you do retire, the broker gets commissions (or a percentage of assets, depending on how he is compensated) regardless of whether or not actually retiring is a good idea or not.

    To put this in perspective, would you ask your real estate agent whether or not you should sell your home? Of course not… the agent wants you to sell / buy a home so that they make their commission. Everyone realizes that the agent only is compensated if a sale occurs and treats them accordingly; not to say that they don’t offer a service and / or advice that could be valuable, but they are extremely motivated to close a sale one way or another.

    How do all these threads work together? Here’s how…

    1) a bear market in stocks can last for a LONG time. Even the rosiest stock forecasts for returns assume that you ride out the downturns without selling and then ride the upward wave. If you get out of the market when it gets choppy, then all bets are off, and bear markets can last for decades
    2) returns for the last 7 years (and the start of the 8th) have been poor even if you “stayed the course”… if you exhibited typical investor behavior and bought high and then sold after they crashed your performance is likely even worse than average. On the other hand, cash has done quite well and bonds even better
    3) a lot of people who glibly make pronouncements about whether or not you can “retire” or provide advice have conflicts of interest that are hard to ignore

    I am not saying to get out of stocks and into bonds or cash because I am no better than the next guy at predicting the market. I do know that if you are going to try to earn the high returns that stocks THEORETICALLY offer you need to stay the course when the seas get choppy, even if it takes decades; if you bail out then you might as well stay out of equities entirely and just keep your money in cash and bonds.

    When you hear people talk about the assumed better return on stocks you might want to listen with a jaundiced ear and think about whether or not they really 1) know what they are talking about 2) have the courage and conviction to stay the course when it gets rough.

    Cross posted at LITGM

     

    10 Responses to “Return Assumptions and the Bear”

    1. Tyouth Says:

      “I am not saying to get out of stocks and into bonds or cash because I am no better than the next guy at predicting the market.”

      Me either. The best thing I ever heard though (I wish I could attribute it) is “Bulls make money, bears make money, but pigs do not”. I take this to mean that, for example, if the bear gets lucky with the high-tech company and the stock price increased 50% in a year perhaps it makes sense for the bear to sell a good portion and take some profit. Similarly, if the bull owns poultry stock that takes a 20% loss for no apparent reason, perhaps it makes sense for him buy some more.

    2. david foster Says:

      1)This study suggests that changes in asset allocation should be done gradually, rather (for example) than slamming the lever all the way over from “all equities” to “all cash.”

      2)A good source for ideas and analysis on valuation is John Hussman of Hussman Funds, who has done a lot of interesting quantitative work (and who really, really hates the so-called “Fed model”)

      3)Speaking of valuation, a lot of people seem to have a hard time understanding that something can be an excellent, fast-growing company but still be a very poor investment. The idea that the market has already discounted the growth seems for some reason to be hard to intuitively grasp.

    3. Carl from Chicago Says:

      I think the quote is “pigs get fat but hogs get slaughtered”…

    4. renminbi Says:

      Is the account tax deferred or not? If not, all the interest is subject to tax (except munis),whereas only dividends are certainly taxable as occurring. Capital gains are only taxable when realized and that can make all the differance. If you hold a broad based ETF with a low expense ratio such as Spiders (9 basis points), capital gains distributions will be very small and you may be able to hold many years.Most mutual funds are rip-offs because their heavy trading causes taxable events-then there are the are the fees, usually in excess of 100 basis points.Then the sales load.Ugh. Why injure oneself that way? The case for stocks becomes far weaker if you trade heavily or hold mutual funds.

    5. renminbi Says:

      FWIW may I suggest reading “The Black Swan”, by Nassim Taleb.He discusses epistemology and the role of “rare” events in markets.One conclusion : much of what is done in the financial world is complete quackery. Nothing here contrary to my experience, but well articulated.

    6. Carl from Chicago Says:

      I agree that is a very good book. I like Taleb a lot.

    7. ElamBend Says:

      Carl,
      Thanks for the post, the timing is perfect as I’ve been thinking about this quite a bit lately, particularly the waiting out the Bear scenario. The solace I take is that I’m in my early 30s. I just wonder if there will be an “Equities is Dead” headline to mark the turnaround a la Business Week.

    8. Lance Says:

      I always enjoy a Barton Biggs mention. Few people are as entertaining a character as old Barton, and while he occasionally whiffs, his deep skepticism is a healthy counterweight to much commentary. Sadly, when he was pointing out that stocks were unlikely to have a reasonable return over this decade, he was not only not listened to by most people at Morgan Stanley, but openly despised for his pessimism. I still remember him being ridiculed by Abby Joseph Cohen of Goldman Sachs during the last blast of the tech bubble for not “getting it.”

      I also second reading John Hussman. He has done some of the best work on what is a reasonable expectation of the long term return from stocks at this point. Jeremy Grantham is likewise doing great work on valuation. Rob Arnott has some good stuff at Research Affilliates.

      One final site is Ed Easterling’s Crestmont Research. Lots of data that shows just how long the long term can be.

      In the case of the returns from 1965 that Barton mentions, once adjusted for inflation you didn’t make any money until the 1990’s on the S&P500 index. Over 20 years. Price matters, and it matters a lot when you get past a few years time. Since somewhere around April of 1998, the S&P500 has lagged t-bills, the so called risk free rate. Not good, not good at all.

    9. Tyouth Says:

      “- S&P 500 Index 1.66%” over the first 7 years of this century.

      Yeah but this is the “dead man investing” (quotes mine) strategy isn’t it”?

      One would have to champion the “buy and hold” mentality. This (buy and hold) doesn’t make any sense as far as I can see. Even if one is only following broad trends in the market; much less analyzing individual investments in the stream of the market.

    10. Robert Schwartz Says:

      I really like Political Calculations. This link goes to: “Mapping S&P 500 Performance, Since 1871”:

      We took all this data and found the nominal annualized rates of return for investments made in the S&P 500 (assuming full re-investment of dividends, and not considering the effects of commissions, fees, taxes or inflation) for initial investments made in each month beginning with, and since, January 1871. We did this for full-year increment holding periods ranging from one year to 130 years.

      And

      We find that in the historical data, the worst case nominal rate of return becomes positive for a 17-year holding period. Likewise, the worst case investment exceeds a 3.0% rate of return after 25 years and 5.0% after 36 years.