Friday, August 19, 2011

Research Affiliates (Rob Arnott) Fundamentals Newsletter: "THE BIGGEST URBAN LEGEND IN FINANCE"

We are fans.*
From Research Affiliates:
Stocks ought to produce higher returns than bonds in order for the capital markets to “work.” Otherwise, stockholders would not be paid for the additional risk they take for being lower down the capital structure. It comes as no surprise, therefore, that stockholders have enjoyed outsized returns for their efforts for most—but not all—long time periods.

Ibbotson Associates, whose annual data compendium covers U.S. stocks and U.S. bonds since January 1926, shows the S&P 500 Index compounding through December 2010 at an annual rate of 9.9% vs. 5.5% for long-term government bonds, an excess return of 4.4%. This return compounds exponentially with time. A $1,000 U.S. stock investment in 1926 would have ballooned to $3 million by December 2010 vs. $92,000 for an investment in long-term bonds, a 32-fold difference.

Emboldened by the 1980s and 1990s (when stocks compounded at 17.6% and 18.2% per annum, respectively), “Stocks for the Long Run” became the mantra for long-term investing, as well as a best-selling book. This view is now embedded into the psyche of an entire generation of professional and casual investors who ignore the fact that much of those outsized returns were a consequence of soaring valuation multiples and tumbling yields. In this issue we examine historical U.S. equity performance from a larger perspective and find that today’s overwhelming equity bias is built on a shaky foundation, reliant on a short and unrepresentative time period.

Let’s Talk Really Long-Term
For those willing to do the homework, longer-term stock and bond data exist for the United States. But that picture isn’t quite as rosy as from 1926–2010; therefore, it doesn’t receive as much attention from Wall Street optimists. From 1802–2010, U.S. stocks generated a 7.9% annual return vs. 5.1% for long-term government bonds. Our realized excess return was cut to 2.8%—a one-third reduction—by adding 125 years of capital markets history!

Of course, many observers will declare 19th century data irrelevant. A lot has changed! The survival of the United States was in doubt during the early part of the century (War of 1812) and during the debilitating Civil War of the 1860s. The United States was an “emerging market”! The economy was notably short on global trade and long subsistence agriculture. Furthermore, there were three major wars and four depressions—two were deeper than the Great Depression—between 1800 and 1870, a span when data on market returns were notably thin. ...MUCH MORE
That was from the March 2011 edition. Here's the latest, "The trouble with quants" (5 page PDF).
Here's the newsletter homepage.

*See also:
June 2011 
Investment manager Rob Arnott’s plan to weather the U.S. ‘debt hurricane’

June 2011 
"Robert Arnott's Magic Indexing Formula"

May 2011 
Robert Arnott: "Why the U.S. GDP number may be as bogus as a three-dollar bill "

and many more, including:
What Risk Premium Is “Normal”?
Up and Down Wall Street: Rob Arnott "After Lost Decade, It's Still Tough to Find Returns "
Equity Risk Premium: "Why the market’s rate of return—and your nest egg—may never recover"
A Really Smart Guy On Stocks, Bonds and Expected Returns 
Up and Down Wall Street: Rob Arnott "After Lost Decade, It's Still Tough to Find Returns " 
Rob Arnott on Consuelo Mack's WealthTrack 
**General Electric Dividend: Good Sign or Management out of Ideas? (GE)

For the rest of our Arnott posts: robert arnott