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Don't Lower Your Expectations on Stocks Just Yet

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What You Need to Know

  • Bond investors seem to accept low returns going forward, Morningstar's John Rekenthaler writes.
  • Bonds have delivered radically different returns over different time periods.
  • Stocks, overall, have performed more consistently, he writes.

Investors may already be accepting the fact that bond returns — and possibly stock returns — won’t be what they were in the past. It seems bond investors have already accepted lower future performance than what has been seen over the past 40 years, but for stock investors, accepting lower returns is not a given.

This is the conclusion of John Rekenthaler, Morningstar’s vice president of research, in his recent column, “What’s the Future for Bond and Stock Returns?

Furthermore, history doesn’t necessary provide a clear baseline for where returns for both bonds and stocks will be in the future.

Long Bonds

Rekenthaler notes that the “history of the U.S. bond market can be summarized in three words: bad, then good.”

The nominal return for long U.S. government bonds annualized from 1950 to 1979 was 2.27%, while from 1980 to 2019, it was 8.91%, Rekenthaler says. He notes that adjusting for inflation, real bond return from 1950 to 1979 was -1.69%, while from 1980 it was 5.64%.

He says: “Not only was inflation higher in the first period than in the second, but the rate of inflation also exceeded the returns from long bonds, meaning that in real terms long bonds were losers. The longer investors held them, the poorer they became.”

Therefore, a $10,000 investment in bonds in 1950 would have returned only $6,000 over the next three decades, while the same investment in 1980 would have grown to $90,000 in the next 40 years. As he says: “For one generation, long bonds meant penury. For the next, they meant prosperity.”

But the generational divide might be due to bonds behaving differently because investors changed, Rekenthaler states. The 1950s generation was coming off the Great Depression, and a 2% yield on long bonds, despite inflation, seemed acceptable, as stocks and cash weren’t performing either.

But that changed in the 1970s, when stocks had better returns than bonds. “Investors therefore demanded more from bonds,” he writes, and at the end of that decade, the 30-year Treasury yield was 10.3%. With bond yields now back at 2%, he says, and inflation projected at 2.3%, investors once again could lose holding these products.

What About Stocks?

Unlike bonds, stocks have performed roughly the same during the same two periods in which bonds were split. Nominal returns from 1950 to 1979 were 10.85%, and from 1980 to 2019, they were 11.81%. Inflation, he notes, didn’t have as huge an impact on stocks. Real returns from 1950 to 1979 were 6.56%, while the later time period shows an 8.48% return.

He says that “for 70 years, equity returns have chugged along, reliably reverting to the mean after brief downturns. The lesson for investors has been not to worry about the hiccups, because soon enough stocks will resume their onward march.”

And of those who declare stocks are dead, he says: “The corpses of such prognosticators are littered on the street.”

He notes three claims that have proved untrue:

Low stock yields: Despite the thinking that stock-dividend rates should exceed Treasury yields to compensate for equities’ higher risk, that isn’t the case, as stocks haven’t been seen as overpriced.

High CAPE ratios: As Rekenthaler notes, Robert Shiller’s cyclically adjusted price-to-earnings ratio attempts to put current stock-market valuations “into context.” That is, a “lofty” CAPE ratio implied reduced stock returns and vice versa. It seems, though, “with only brief exceptions,” the ratio has exceeded its historic norms since introduced.

Federal Reserve manipulation: The Fed’s “interventionalist tactics” of propping up the stock market, as some claim, would have a day of reckoning, Rekenthaler says, but that hasn’t happened. “Such failures have led me to distrust predictions of future stock-market woes,” he says.

The bottom line, he says, is that even though bond investors might have accepted lower future performance, the jury is still out for stock investors.