My colleagues are never surprised to hear me say, “Show me the evidence” when discussing any given investment theory (given my background as a recovered litigator). But how should we interpret evidence when recognized experts draw apparently contradictory conclusions from the same set of facts?
June provided a good example. Early in the month, I attended an investment conference in Florida, where Wharton Professor Jeremy Siegel was a featured speaker. At the same time, my business partner attended a conference in San Francisco featuring Rob Arnott, head of Research Affiliates and former editor of the Financial Analysts Journal.
The evidence reviewed by these two respected investment academics was 200 years of “real returns” from the U.S. stock market. From the same data, these luminaries drew diametrically opposed conclusions.
Regular readers of this column will remember that “real returns” are arrived at by eliminating the effect of inflation on nominal returns. If the value of your portfolio goes up by 10 percent, but the value of the dollar declines by a like amount in a given year, you’ve merely treaded water and your real return is zero.
Looking at the two centuries of real return data for stocks, Siegel finds a steady trend line describing an upward trajectory of about 7 percent a year. Siegel, author of the best-selling Stocks for the Long Run, points out that, despite the rapid run-up in stock prices since early March, the market currently lies well below the trend line he discerns. Thus, Siegel is now about as bullish as he ever is.
Instead of drawing a single trend line, Arnott draws seven lines parallel to the x-axis, indicating long periods in which the stock market made no new highs. These “droughts” lasting more than a decade, as Arnott calls them, consume fully 80 percent of the two-century data time span.
The shortest of these “droughts” lasted 17 years (1881 to 1898); the longest lasted 44 years (1835 to 1879). In the past century, the longest period in which the stock market made no new highs lasted 30 years (1929 to 1958), followed closely by a 28-year period (1965 to 1993). The most recent unsurpassed high occurred in 2000, making 2009 number nine of the current “drought.”
So which is it: drought or deluge? Let’s assume the current drought lasts 20 years. If the market does in fact reach a new high in 2020, what kind of returns would we experience over the next 11 years while waiting?
The all-time closing high of 1,527 on the S&P 500 occurred in March 2000. During the ensuing nine years, the consumer price index (CPI) has risen from 171.2 to a recent 213.8. Thus, $1 in March 2000 is worth about $0.80 today. Because the S&P 500 Index is derived from stock prices, we have to adjust the March 2000 figure upward by dividing the index level then by 0.80. Measured in today’s dollars, the S&P closed at 1,908 nine years ago.
We don’t need to know the actual level of inflation for the next 11 years to determine what kind of returns we’ll experience, since we’d be applying the same divisor to both the numerator and the denominator in the return calculation. It turns out, with the S&P standing at 893 as I write this, a rise to 1,908 in 11 years would represent an annualized return of approximately 7 percent considering price appreciation only. Adding in the typical stock dividend of 2 percent for the S&P over the past decade would bring the annualized return to 9 percent.
Even if we’re in one of Arnott’s prolonged droughts, an annualized return of 9 percent, or even 7 percent, going forward would be attractive in a world where a “risk-free” return available today from an 11-year Treasury bond is barely 4 percent before adjusting for inflation. Thus, while Arnott’s analysis of the evidence is valid, it doesn’t preclude the likelihood of reasonable returns from stocks going forward. One need not be as sanguine about stocks as Siegel to stick one’s toes into the market at present levels.
