Forty years is the duration of the accumulation phase for most wage-earners. How was it that common stocks--the core of virtually every retirement portfolio--failed to outperform ultra-conservative Treasury bonds? More important, what lessons should investors take from this episode of capital market inversion?
Look closely at the data in Arnott's study, and some answers emerge. Since 1926, equity returns over 40-year periods have been reasonably consistent, staying mostly within a band of 9% to13%, and averaging a healthy 11%.
Until 1980, Treasury bonds were similarly predictable, returning a stodgy 2% to 4%. But then things changed, and the 40-year return on Treasury bonds began a steady upward progression, peaking at 8.8% in March--barely eclipsing equity returns of 8.6%. A prescient investor who bought Treasury bonds at 14% yields during the inflationary decade of the 1970s did very well relative to an equity investor over the ensuing 40 years.
But that performance record for Treasury bonds is not sustainable. If yields on 20-year Treasuries--the basis for Arnott's study--remain at their level of 3.3% as of late April (when I wrote this column), we are past the peak in their trailing 40-year performance. A sustained rally from today's levels is impossible; yields simply have no room to go lower.
This is a classic case of the inadequacy of past returns to predict future results. Arnott readily admits that Treasury bonds would be a "terrible" investment right now.
While Treasury bonds are unattractively priced, equity prices tell a different story. As Arnott explains in his paper, equities have historically earned a risk premium of 2.5% per year--the additional return they get, relative to risk-free bonds--to compensate for the additional risk they bear. Compounded over 40 years, that 2.5% margin makes an enormous difference to wealth accumulation.
Historically, equity investors have done well when they made their initial investment at market levels with low P/E ratios. Arnott's data provide a useful illustration of this principle. In the graph below, I used Yale Professor Robert Shiller's "normalized" P/E ratios, where earnings are averaged over a rolling 10-year period, to incorporate the effects of a full business cycle.
Here I compare the 40-year equity performance against the 10-year normalized P/E ratio at the beginning of the investment. The P/E ratios are lagged by 40 years so for example, January 2008 corresponds to January 1968.
In January 1929, when normalized P/E ratios peaked over 30, investors would have been well-advised to avoid the equity markets; subsequent 40-year performance reached its lowest level over the time period shown.
In the depths of the Depression, P/E ratios reached their lowest point--nearly 5--and subsequent 40-year performance peaked at nearly 14%.
Investing when P/E ratios are below 15--ideally, below 10--yields 40-year performance of 12% or more--modestly good news now since the normalized P/E ratio as of March 2009 was 13.1.
Normalized P/E ratios tell only part of the story. In a recent research note, Van Hoisington and Lacy Hunt of Texas-based Hoisington Investment Management showed that equity risk premiums were actually negative during three prominent episodes of deflation: in the U.S. from 1874 to 1894 and from 1928 to 1941, and in Japan from 1988 to 2008.
And deflation has not been kind to equity investors. Hoisington and Hunt argue that U.S. fiscal and monetary policies are unlikely to be inflationary--at least not in the near term--and investors should structure portfolios for an episode of deflation.
They conclude that "on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, over-indebtedness, declining income flows and slow growth."
Asset class allocation depends heavily on forecasts of inflation versus deflation. Deflation is not a foregone conclusion; for every reputable economist or analyst currently forecasting deflation, at least one stands on the other side of the fence forecasting inflation.
Whichever side of this debate you take, do not be guided by the prior 40 years of spectacular Treasury returns or by recent lackluster equity market performance.
Robert Huebscher, firstname.lastname@example.org, is CEO of "Advisor Perspectives" (www.advisorperspectives.com), a free, online database and weekly newsletter for wealth managers and financial advisors.