2023-12-31 03:37:57 ET
Summary
- New data challenges the notion of a guaranteed equity risk premium, showing that stocks and bonds perform about the same over multi-decade periods.
- The historical record reveals that stocks and bonds have alternated in terms of outperforming each other, debunking the "Stocks for the Long Run" theory.
- The research suggests that investors may not be adequately compensated for the risk they take when investing in stocks over long periods.
The Equity Risk Premium: Fact or Fiction?
The question of the equity risk premium ((ERP)) has remained a puzzle for many years. Academics have sought to explain the extent of the premium in the ERP in the 20th century record using different models and techniques. Mehra and Prescott 1985 brought forth the idea of an equity risk premium puzzle, questioning why the ERP was so large in the available data at the time (100-year record). New data and a new paper is shedding some light on the issue of why the ERP was so large in the 20th century data set, and further, that this ERP collapses entirely over multiple decades when data from the 18th and 19th century is included. Here is the author Edward F. McQuarrie describing his research.
Stocks for the Long Run? Sometimes Yes, Sometimes No
This may seem inconsequential to an investor seeking to design their portfolio in 2023, but I assure you there are profound implications to how we build portfolios based on this data. Most notably, that the ERP of 5% that we have come to think of as our birthright in US equities may in fact be simply an anomaly in the historical record.
Even more of an outlier is the period from 2009-2023 which saw excess returns between stocks and risk-free short-term treasuries climb to 12.46%! This was largely as a result of a perfect merger of multiple factors. First, an expanded role of the Federal Reserve, including monetary policy of quantitative easing which pushed equities up and rates down to all-time lows, and even saw the Fed taking unprecedented steps to invest directly in specific markets in 2020. Second, incredible fiscal accommodations, first from the 2008 financial crisis, then again in the 2020-present pandemic period where cash was injected directly into consumers bank accounts.
As Robert Arnott of Research Affiliates noted in his 2009 article in the Journal of Indexes, Bonds why Bother?
It's now well-known that stocks have produced negative returns for just over a decade. Real returns for capitalization weighted U.S. indexes, like the S&P 500 Index, are now negative over any span starting 1997 or later. People fret about our "lost decade" for stocks, with good reason, but they underestimate the carnage. Even this simple real return analysis ignores our opportunity cost. Starting any time, we choose from 1979 through 2008, the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor."
In a previous analysis in 2000 entitled "The Death of the Risk Premium" Arnott along with his co-author Ronald J Ryan asked the fundamental question "What if Stocks Don't Beat Bonds Long Term?" They laid out the following chart:
In the decade following this piece, stocks crashed violently from 2000-2009 investors saw returns in the Nasdaq-100 of -49.18%, and -9.84% for the S&P 500, the only segment with a positive return was small caps, which clocked in at 48.64%.
Many see this as an anomaly in the historical record, but to the contrary when we look at data over centuries, we see this pattern again and again. High flying decades for stocks, followed by a mathematically required return to the mean that sees stocks crash, and with it go long term returns.
As Arnott analyzes in his aforementioned 2009 paper:
In fact, from the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, our 20-year bond investors win by a nose. We're now looking at a lost 40 years! Where's our birthright … our 5 percent equity risk premium? Aren't we entitled to a "win" with stocks, by about 5 percent per year, as long as our time horizon is at least 10 or 20 years?
The evidence would contend, the answer is a resounding, No.
Arnott furthered his 2000 analysis with a paper he co-authored in 2002 with Peter Bernstein entitled 'What Risk Premium is 'Normal'? They looked at the returns since 1802 and found the ERP was more conservatively at 2.4%. This excellent quote from the paper sums up their findings well:
"The consensus, that a "normal" risk premium is around 5%, was shaped by a deeply rooted naivete in the investment community, where most participants have a career span reaching no further back than the monumental 25-year bull market from 1975 to 1999. This kind of mindset is a mirror image to the attitudes of the chronically bearish veterans of the 1930s. Today, investors are loathe to recall that the real total returns on stocks were negative over most 10-year spans during the two decades from 1963 to 1983, or that the excess return of stocks relative to bonds was negative as recently as the ten years ended August 1993.
When reminded of such experiences, today's investors retreat behind the mantra that things will be different this time. But no one can genuflect before the notion of the long run and deny that there will again be such circumstances in the decades ahead. Indeed, these crises are more likely than most of us would like to believe.
All of the evidence we have gathered here demonstrates that the normal risk premium is not 5% but has been much closer to a modest 2.4%. A 2.4% risk premium has historically served to entice investors to accept equity market risk. A negative risk premium, as appears to prevail today, is a symptom of irrational valuation. As a consequence, investors greedy enough or naïve enough to expect a 5% risk premium, and overweight equities accordingly, may well be doomed to deep disappointments in the future as the realized risk premium falls far below this inflated expectation.
Stocks Beat Bonds Some of The Time
Edward F. McQuarrie's paper published in the Financial Analysts Journal had the following abstract:
"When Jeremy Siegel published his "Stocks for the Long Run" thesis, little was known about 19th-century stock and bond returns. Digital archives have made it possible to compute real total return on US stock and bond indexes from 1792. The new historical record shows that over multi-decade periods, sometimes stocks outperformed bonds, sometimes bonds outperformed stocks and sometimes they performed about the same. New international data confirm this pattern. Asset returns in the US in the 20th century do not generalize. Regimes of asset outperformance come and go; sometimes there is an equity premium, sometimes not."
Here we now have a greater historical record, and this new data appears to turn everything we think we know about modern finance on its head. No guaranteed equity risk premium? Bonds beating stocks over multiple decades? What exactly does the data say? We turn to the graphic below.
"During the decades following 1981 (right panel), stocks and bonds performed about the same. Occasionally, stocks soared above bonds, as during the dotcom boom, but as late as December 2008, stocks had fallen behind bonds in what by then had been a 27-year horse race.
The right panel of Figure 1 offers little to support "Stocks for the Long Run." Stocks did very well in the boom that began in 1982-but so did bonds. Periods where stocks soared ahead of bonds were offset by plunges that took stocks back down to the bond line..."
This is an incredible paper that disproves the stocks for the long run theory as a predictable certainty as it is portrayed today. Instead, it is a horse race decade by decade to see whether stocks or bonds will win. This flies in the face of the research underpinning what every financial advisor in this country has been told, taking more risk in stocks provides a higher return over the risk-free rate as long as your holding period is long enough. This new research shows this is not always the case.
Financial Analysts Journal
"The new historical record tells a different story. Table 1 provides overall results with a breakout by sub-period, using 1862 and 1942 as the break points. Recall that the new stock record shows the greatest deviation from the old record before the Civil War and that World War II marked the beginning of the worst bond bear market in US history... the subperiod results in Table 1 do not support "Stocks for the Long Run." Prior to the Civil War, the pattern was the reverse: The longer the holding period, the greater the odds that stocks would underperform bonds. In fact, for holding periods of 30 and 50 years, in that era stocks always lost to bonds. Conversely, the most recent period is strongly supportive: From 1942 the odds that stocks outperform start high and increase with holding period, until by 30 years the odds converge on 100% "
To further the case for bonds vs stocks we look to the international data, which provides for a convincing record of bond vs stock outperformance on a risk adjusted basis.
As laid out in a Financial Times piece :
"Elroy Dimson, professor of finance at Cambridge university's Judge Business School, has for several years co-authored the finance industry's definitive almanac of global long-run asset return data, stretching it back to the start of the 20th century. This work has provided a quantitative check to universalist beliefs in the dependability of equity outperformance. Instances of 20-year holding periods in which equities have been beaten by bonds or even cash are not uncommon across developed markets. In the 50 years ending 2019, the Dimson team reported that returns from world ex-US equities and government bonds were approximately equal at 5.0 per cent and 5.1 per cent, respectively."
Risk of Loss is Greater Than you Think
"His account captures many more failures, reducing survivorship bias, and a stunningly different long-term story. The impact of survivorship is no small detail. The old history, McQuarrie tells me, had some glaring omissions. The biggest omission from previous data, the Second Bank of the United States, accounted at its peak for almost 30 per cent of total US market capitalisation, around the combined weight of the Magnificent Seven in today's S&P 500. The bank failed in a financial panic in 1837. -Financial Times
When we expand the data set, we see that even over 50-year periods, the odds of beating a portfolio of bonds are no more than 2/3rds. Still the majority of the time analyzed, and unlikely to upend anyone's asset allocation plans, but it shows just how exceptional the 20th century record was.
Many will dismiss this research as showing an undeveloped US record, and therefore will conclude the data is not applicable to the future. Investors tend to exhibit a high degree of recency bias. Excitement about AI and the digital revolution makes investors believe that their above average returns they have enjoyed for the past 15 years are going to continue into the future. This is unlikely to be the case.
Consider this analysis of gain needed to get back to even given a specific unit of loss using the 2008 financial crisis as an example. The investor lost 55.3% and yet needed 123% return just to get back to even! This means even after the 123% return; the investor would still have trailed a simple portfolio of risk-free T-Bills. At today's rates this situation is even more acute. As one market professional told me recently, "when the Fed is paying you not to take risks, don't take risks."
Beaumont Capital Management
Few investors truly understand the risk they are taking when they invest in stocks. This is especially true after a 15-year raging bull market. For each unit of risk you are taking you are likely NOT being compensated even over long periods. Furthermore, investors commonly underweight the risk of loss and instead allow greed to determine their portfolio allocation. We saw this in multiple periods of over bullish sentiment, in 1929, 1987, 2000, and 2008. When over bullish sentiment combines with an overbought market as we see today the result is usually heightened volatility. Even routine losses of 20%-30% require returns of up to 43% just to get back to even.
Conclusion
Asset prices are a descriptive account of economic conditions, policy choices, entrepreneurial successes - and of course their failures. Investors holding Russian financial assets in 1917 or Chinese ones in 1949 were expropriated by policy choices. Holders of Japanese index-trackers in 1989 are still waiting to be made good on their initial investments. Dimson's work on 20th century returns has long found US equity market performance to be exceptional. The new data does not diminish the exceptionalism of postwar American equity performance but suggests it could be an exceptional episode. - Financial Times
The conclusion of this piece is not for investors to abandon equities entirely in favor of fixed income. But the conclusion should be that the notion that 100% equities is the ideal portfolio given a 5% ERP, may be a conclusion arrived at prematurely and highly influenced by the 1942-2023 period which saw incredible ERP.
A more balanced conclusion seems to be in order. Each individual investor needs to take into account their own risk, return, and time horizon characteristics when building a portfolio to attain their goals. Taking into account the total value needed to come back from a loss is an important part of gauging one's true risk tolerance. In many periods high flying stock returns give way to a subsequent period of drastic losses, which result in a full cycle investment return that does not outperform risk free-Treasury bonds.
Ultimately the takeaway from this research is to learn the lessons of history, before we are bound to repeat them. Most of all, investors must be humble enough in this time of bullishness to remember what it felt like to lose significant money in stocks and choose the right allocation to achieve their long-term goals. Playing musical chairs with excessive allocations to equities is a recipe for disaster. The historical record is filled with episodes of overvaluation, where stock investors are still left waiting to get back to even after the inevitable collapse. In the case of Japan, they have been waiting for 34 years.
Macrotrends Nikkei 225 Index - 67 Year Historical Chart
It should be noted that bond yields peaked in 1990 at 8.2651%, they currently sit at 0.616%. That is a 92.5% collapse in bond yields. Yet, an investor in 1989 was far too focused on the growth in equities to even consider buying Japanese Government Bonds ([[JGB]]).
Regardless of what investors choose, the returns that are ahead for stocks and bonds will be highly influenced by a range of factors over which investors have little to no control. What they do have control over is their savings rate, and what asset allocation they choose to hold, choose wisely.
For further details see:
Bonds Beat Stocks Over Decades