Using history's lessons to evaluate today's investments
The odds favour equities, writes John Rekenthaler.
The Nifty 50s
History permits us to observe with unaffected eyes, to see things our predecessors missed. It is not that they lacked our intelligence (to put the matter gently), but rather that they were products of their times. Perhaps after conducting the exercise, we can bring a like mindset to today’s investments. Perhaps we can avoid becoming too caught up in our particular moment.
In that spirit, let’s revisit 1950s investment prices. The chart below shows the dividend yield on large-company stocks for that year, along with interest rate paid by long-term government bonds, and the previous decade’s annualised inflation.
Wow! Inflation had averaged more than 5 per cent per year during the 1940s, and yet American investors demanded only a 2 per cent yield from long bonds, which possessed no ability to combat inflation. Meanwhile, the equities of companies that could and did raise their prices in response to inflation, thereby growing their earnings, distributed 8 per cent. At first glance, those numbers seem as if they should have been reversed. Bonds should have yielded 8 per cent, with stock payouts being 2 per cent.
Clearly, 1950s investors had the Great Depression on their minds. In the 1930s, any guaranteed income whatsoever was a bargain, given that stock dividends shrunk, many corporate bonds defaulted on their obligations, and consumer prices had declined rather than risen. In that light, a 2% Treasury payout was sufficient, while stocks needed to distribute a much higher amount, because their yields were not to be trusted.
Also, the economy had recently been poor. The “postwar boom” did not begin immediately after the conclusion of World War II, when the soldiers returned home. It took a few years to arrive. In 1950, the nation’s gross domestic product was slightly below its 1945 level, although production had been slowly increasing over the previous three years. Investors could therefore have been pardoned for believing that economic weakness was a greater overall danger than overheating.
However … the point of this review is not to place ourselves fully in the past, but instead to appreciate why our predecessors believed as they did, before stepping aside to examine the situation dispassionately. Could another powerful recession have occurred? Sure, it could have. Had investment prices overly discounted that possibility? They certainly had. The numbers suggested to buy stocks heavily and then buy some more.
Over the next 30 years, US large-company stocks grew by 10.85 per cent annually, while long government bonds made 2.27 per cent. That is the charitable view. The less charitable approach is to consider each asset’s cumulative, inflation-adjusted performance. In real terms, large stocks gained $5.73 during those three decades on each dollar invested. Meanwhile, long bonds lost 41% of their value. Ouch.
Entering the 1980s
By the end of the period, when 1980 arrived, valuations had flipped.
What a difference 30 years made. Long government bonds went from possessing one fourth of equities’ yields to double their amount. No longer did investors fear recession more than inflation. Although the former remained a concern, inflation had become the overriding threat. Consequently, bondholders demanded a substantial premium. Whereas in 1950 long government bonds yielded 3 percentage points less than the previous decade’s inflation rate, by 1980 they were paying 4 points more. Bonds carried a large margin of safety.
Once more, the era’s investors had their reasons. Inflation had subsided for a while before once again crossing the 4 per cent mark, in 1968. From then it just kept rising, and seemingly would not stop. It exceeded 12 per cent in 1974, came down somewhat as oil prices stabilised, and then surged again in 1979, surpassing 13 per cent. In that light, an 11 per cent bond yield did not necessarily seem excessive to them.
Nor does it to me, considering the available information. In 1980, there was a significant chance that inflation would continue to rise, with global governments unable to protect their currencies. Therefore, I do not regard that period as presenting an obvious investment opportunity. That said, were inflation to be conquered, both stocks and bonds were priced to profit handsomely.
And so they did. From 1980 through 2009, large stocks returned 11.12 per cent annually in nominal terms, and 7.45 per cent in real terms. Adjusted for inflation, they outdid their previous performance. This time, though, long bonds followed suit. Instead of losing real money, as had occurred during the prior 30 years, they gained an annualised 5.93 per cent after inflation, which led to a 462% cumulative real return.
Considering today
Now for the current markets. What do they signal to the disinterested observer?
Hmmm. In 1950, stocks distributed much more than the prevailing inflation rate and bonds paid much less. Thirty years later, the positions had reversed, with bonds yielding well above the previous 10 years’ recorded inflation, while equities were 2 percentage points below. Today, all three numbers are roughly similar.
Stocks are undoubtedly expensive. Only from 1999-2001 were their yields lower. One can defend their valuations by pointing to the past decade’s low inflation rate--but doing so would violate the terms of this exercise, which is to avoid being swayed by current arguments. The broader view breeds skepticism. In 1950, investors were undaunted by inflation. They were wrong. Thirty years later, they feared it. Also wrong. Now they are sanguine. Such confidence is unconvincing.
If equities’ prospects are mixed, they at least surpass those of bonds. Should inflation revert to the mean, stock prices will suffer, but after a while companies will compensate by increasing their prices, just as they did through the 1970s and 1980s. No such luck for government bonds, which have shed the margin of safety they possessed in 1980. If inflation resurfaces, they will be blitzed. Even if not, they will likely trail equities, probably by a large amount.
In summary, adopting the broad perspective offers a unambiguous verdict on today’s investments: Better stocks than bonds. Equities aren’t remotely as attractive as they were in 1950; at today’s prices, they do not represent that sort of opportunity. But neither is the contest a toss-up, as in 1980. The odds now clearly favour equities.
John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
