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The new study, which began circulating last month as a working paper, is titled "Are Stocks Really Less Volatile in the Long Run?" Its authors are Lubos Pastor, a finance professor at the University of Chicago Booth School of Business, and Robert F. Stambaugh, a finance professor at the Wharton School of the University of Pennsylvania. A copy is at http://ssrn.com/abstract=1136847. The professors don't disagree that, historically, the stock market's returns over various 30-year periods have been surprisingly consistent. Periods of particularly good returns have been followed by subpar ones, and vice versa - a process that statisticians call reversion to the mean. Prof. Jeremy Siegel, also of Wharton, and the author of "Stocks for the Long Run," is often credited with demonstrating that mean reversion has been at work in the American stock market since 1802. In an interview, Professor Stambaugh said that while Professor Siegel's research shows that mean reversion is powerful, it is hardly the only force affecting the stock market's long-term returns. Because estimates of those other forces are imprecise, Professor Stambaugh said, uncertainty about market fluctuations increases with the holding period - the opposite of what happens because of mean reversion. One example of such a force, Professor Stambaugh said, is global warming. Its impact on the economy over the next 12 months is likely to be quite small, he said. But expand the horizon to the next several decades, and the possible effects of global warming range from negligible to catastrophic. It is one thing to acknowledge the existence of uncertainty, but quite another to measure its influence on long-term market volatility. To do that, Professors Pastor and Stambaugh rely on a statistical approach pioneered by the Rev. Thomas Bayes, an 18th-century English mathematician. Bayesian analysis is often used to assess the uncertainty of future outcomes, based on a formula for updating the probabilities of given events in light of new evidence. This approach is quite different from traditional statistical measurements of probabilities based on historical data. Applying Bayesian techniques, the professors found that reversion to the mean isn't powerful enough to overcome the growing uncertainty caused by other factors as the holding period grows. Specifically, they estimated that the volatility of stock market returns at the 30-year horizon is nearly one and a half times the volatility at the one-year horizon. Why don't traditional measures of volatility, such as standard deviation, pick up this phenomenon? Those measures focus only on how much the stock market's shorter-term returns fluctuate around the long-term average, Professor Stambaugh says. As a result, they ignore uncertainty about what the average return might itself turn out to be. For example, he said, it is possible that the standard deviation of the market's returns over the next 30 years could end up the same whether its average annual return over that period is 20% or zero. What about Professor Siegel's finding that the stock market has produced an annual average inflation-adjusted return of close to 7% since 1802? In an interview, Professor Pastor emphasized that the last two centuries could easily have been less hospitable to the United States, most likely lowering the stock market's returns. An investor couldn't have known in advance that the United States would win two world wars, for example, or emerge victorious from the cold war. In any case, he said, there is no guarantee that the next two centuries will be as kind to the domestic equity market as the last two. Professor Siegel acknowledged the theoretical uncertainty of forecasting stock market returns, but said it was hard to quantify it. He said the methods that Professors Pastor and Stambaugh used to measure the uncertainty were "very much outside of the standard statistical techniques." But Professor Pastor says that these methods are better suited than the standard techniques for quantifying the uncertainty faced by real-world investors. Even if Bayesian approaches have yet to become mainstream in financial research, he adds, they have become much more widely used in recent years. What is the investment implication of the new study? Other things being equal, Professor Stambaugh says, you would probably lower your portfolio allocation to stocks. But by how much? It's impossible to generalize, since the answer depends on your time horizon and what else is in your portfolio. From the study: Conventional wisdom views stock returns as less volatile over longer investment horizons. Siegel (2008) reports that variances realized over investment horizons of several decades are substantially lower than short-horizon variances on a per-year basis. Explanations for lower variance at long horizons commonly focus on "mean reversion," whereby a negative shock to the current return is offset by positive shocks to future returns, and vice versa. We find that stocks are actually more volatile over long horizons. At a 30-year horizon, for example, we find return variance per year to be 21% to 53% higher than the variance at a 1-year horizon. We show that mean reversion is only one of five components of long-run variance: (1) i.i.d. uncertainty (2) mean reversion (3) uncertainty about future expected returns (4) uncertainty about current expected return (5) estimation risk. The component making the largest contribution at the 30-year horizon reflects uncertainty about future expected returns. The uncertainty about future expected returns component is often neglected in discussions of how return predictability affects long-horizon return variance. Such discussions typically highlight mean reversion, but mean reversion-and predictability more generally-require variance in the conditional expected return, which we denote by m. That variance makes the future values of m uncertain, especially in the more distant future periods, thereby contributing to the overall uncertainty about future returns. The greater the degree of predictability, the larger is the variance of m and thus the greater is the relative contribution of uncertainty about future expected returns to long-horizon return variance.
So it's time for investors to reset their expectations, many market strategists say. At the very least, don't count on the market normalizing, or "reverting to the mean," with much speed. And don't count on the market recouping all its losses for several more years. Setting aside specific problems now facing the economy - like the credit crisis and the continuing troubles in the housing and financial sectors - the math of recovering from downturns of this magnitude is hard to overcome quickly. James B. Stack, editor of the InvesTech Market Analyst, studied bear market recoveries since 1929; he found that after the most significant downturns - like this one - it has taken more than seven years for stocks to fully recoup losses. For example, it took 7.2 years after the start of the bear market in 2000 for stocks to reach a bottom and then to climb back to the 2000 peak. After the bear started growling in 1973, it took 7.5 years to return to the high. And after the 1929 crash, equities didn't return to their previous peak for another quarter of a century. The current bear market started on Oct. 9, 2007. Based on the average recoveries of the past, the Dow may not make it all the way back to its peak of 14,164 until late 2014. And some market observers say it could take significantly longer. But don't stocks usually bounce aggressively off their lows? And aren't stocks supposed to perform much better than average after years when they perform much worse than average? Maybe not. A recent report by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School found that the payoff for investing in stocks following bad years was only slightly better than after good ones. The report looked at global stock market performance going back to 1910. In five-year periods after the worst years in the market, stocks returned 7.1 percentage points above the prevailing yield on a three-month Treasury bill. Following the best years, stocks gained 6.8 points above cash. The study was part of the 2009 Credit Suisse Global Investment Returns Yearbook. "Betting on quick mean reversion is a dangerous thing," Professor Dimson said. But assume for a moment that the market is due for a big snap-back. Even if that were to occur, stocks would still have a steep mountain to climb. "We could have a legendary run off the lows, but it may still take us 10 years to get back to our old highs," said Jeremy Grantham, chairman of the investment management firm GMO. Historically, bull markets have gained around 38% in their first 12 months. That amounts to more than a third of the total gains throughout a typical bull market's life. Let's assume that such an initial surge happens this time. The Dow is trading 7,278. A 38% rise would lift the Dow to 10,043. Even assuming a 10% annual climb thereafter - a big assumption in tough times - it would take nearly four more years to get back to even. That would bring us to 2013. Investors who bank on 10-percent-plus returns may be fooling themselves, says Robert Arnott, chairman of the investment management firm Research Affiliates. "The folks who are thinking that we could go back to a sustained period of double-digit annual returns for stocks haven't really studied their history," he said. Based on long-term returns of the S&P500 index, including dividends, Mr. Arnott said it was reasonable to expect that stocks might generate annual returns of around 8.5%. In the 1990s, he noted, earnings growth was higher than average. That, as well as investors' willingness to pay higher prices for each dollar of earnings, accounted for the outsize market gains in that decade, he said. But that kind of euphoria about stocks will probably not be repeated anytime soon, as price-to-earnings ratios for stocks have fallen back in line with their historical norms and are well below their recent highs. "We have to move people away from the mind-set that anything less than double-digit returns is disappointing," Mr. Arnott said. Here's another way to think about it: Even if it takes 10 years for the Dow to claw back to its old highs, at an annual rate of nearly 7%, "you would have still done very well - certainly better than in T-bills," Mr. Dimson said. Single-digit stock returns may not seem all that thrilling, compared with the huge numbers posted during the bull market of the '90s. But for many investors, a stretch of modest returns might be a great relief after the losses of the last few years.
The next biggest annual decline in wealth came in 2002, when household net worth fell 3% after the collapse of the technology bubble. The most recent loss of wealth is staggering and will probably put further pressure on the economy because many people will have to spend less and save more. Most of the wealth was lost in financial assets like stocks, which tumbled at the end of last year. The Standard & Poor's 500-stock index, for instance, fell 23% in the fourth quarter. The value of residential real estate, the biggest asset for most families, fell much less - $870 billion, or about 4%. Even the richest among us have become a lot poorer. This week, Forbes magazine published its list of the richest people in the world. At No. 1, Bill Gates, still had $40 billion to his name, but that was down $18 billion. The wealth of Warren E. Buffett tumbled $25 billion, to $37 billion. The loss of wealth is concentrated among the most affluent Americans, in large part because they own more stocks and bonds than the rest of the country. Only about 50% of households own stock, and many of them own relatively small sums in retirement accounts. As a result of their greater wealth and higher incomes, the affluent tend to spend a lot more than their share of the population would imply. The top 20% of income earners spend more than the bottom 60% of income earners, according to calculations by Tobias Levkovich, the chief United States equity strategist at Citigroup. "When their wealth is mauled, they are not particularly interested in spending," Mr. Levkovich said. The Fed report released on Thursday also showed that total borrowing and lending increased at an annual rate of 6.3% in the fourth quarter, mostly as a result of increased borrowing by the federal government to finance its operations and various bailouts of the financial system. The government's borrowing increased at an annual rate of 37%. But borrowing by households dropped 2%. Lending to businesses was up 1.7%. Recent surveys of loan officers by the Fed have shown that companies have been drawing down lines of credit that were established in the past, and that only a small fraction of the lending to the private sector is through new loans, which are much harder to obtain than in recent years.
You be the judge. These are not individual stock tips. You need to do your own homework. And of course dividends can be cut. If business keeps getting worse many will be, right across the market. But these are, on the whole, pretty solid companies. They are not financials. You'd expect their businesses to hold up pretty well in almost any circumstance except the end of the world. Any one or two companies can get into difficulty, of course, but it would remarkable indeed if they all fared badly. The "efficient market hypothesis" used to claim that, when it came to the stock market, "the price was always right" - in other words if, say, "Jellyfishforpets.com" was trading at $180 a share, then by golly, that's what it should be trading at, and who could possibly say it was overvalued? If you think that's a pretty silly line of thinking, you're right. But many people in finance really did believe it, including some otherwise intelligent ones - dotcom mania and all. It was something so stupid only an expert could believe it. That theory may be pretty much dead today. But we are all at risk - and I include myself - from its insidious evil twin: Efficient market hypnosis. This is where the market simply lulls us into submission by constant repetition. You can't fight the tape. If a perfectly good stock has fallen 40% in value, then, by golly, efficient market hypnosis makes us think there must be an excellent reason for it. Anyone minded to accept the verdict of the stock market should remember that it was at work a couple of years ago in exactly the opposite direction. Lots of people - and I was not immune - were lulled by the overpowering force of the tape upwards. Over time it is very hard to stay completely aloof. I knew people who had argued, persuasively, for years that deep trouble was coming. But every time I wrote something on the subject the markets went up another 10%. After a while we all started to sound like Chico Marx: "Who you gonna believe - me or your own eyes?" Even the hardiest soul can get hypnotized. You can look at the tape and think: Well, I guess we're wrong. The economy is probably going to be much worse, for much longer, than many people expect. But whether these depressed shares are priced correctly, or too low, is another question.
Yet even the most skeptical investor can benefit from a potential recovery without committing to a large equity stake, several strategists say. The idea is simple. Although in general it is smart to rebalance by moving money from the best-performing assets to the underachievers, one need not dive into stocks. Rather than selling Treasury holdings - the only asset that's done well lately - to buy more shares of beaten-down stock, consider shifting some of that money into beaten-down investment-grade corporate bonds instead. "Think of it as your Plan B," said Ernest M. Ankrim, senior markets adviser for Russell Investments. "It's a subdued asset relative to stocks but which has the possibility of giving me decent returns if the economy improves." To be sure, corporate bonds could still lose money, especially if an economic recovery doesn't materialize quickly. This is particularly true among so-called high-yield or junk bonds, non-investment-grade debt of companies with worrisome balance sheets. Last year, the average high-yield bond fund lost a whopping 26%, according to the research firm Morningstar. That's why some strategists emphasize higher-quality debt. Even so, the average intermediate-term investment grade bond fund fell by nearly 5% in 2008, and many portfolios lost more than 15%. Still, in relative terms, that was a far cry from the 37% loss suffered by stocks in the Standard & Poor's 500-stock index, Mr. Ankrim said. This strategy is timely, he added, because falling stock prices and rising market volatility continue to deter investors from rebalancing portfolios by shifting more heavily into equities. "Rebalancing may be too much to ask of some investors who've lost more than 50%," he said. Moreover, there are some unusually good values among investment-grade corporate bonds - assuming, of course, that the economy is on track for a recovery sometime soon. As corporate bond prices have sunk, their yields have soared. How much? Since 1989, the difference in yields between 10-year Treasury securities and 10-year corporate bonds with a Baa-rating - the lowest rung among the so-called investment-grade bonds - has averaged about 1.9 percentage points, Mr. Ankrim noted. But thanks to the heightened fear in the financial markets, this yield spread jumped to as 7.4 percentage points late last year. So far this year, it remains well above six points. With 10-year Treasury notes yielding 3.0%, this means you can find some high-quality corporate bonds yielding 9%, around the historical return of blue-chip stocks. Now, consider the possibility that the recession ends fairly soon. In that case, the spread between Treasury and corporate bond yields would likely narrow - and corporate bond prices would generally rise. The combination of price appreciation and healthy yields would lead to solid total returns for corporate bond investors, said Robert D. Arnott, chairman of the investment management firm Research Affiliates. Of course, there's also a substantial possibility that the economy will look bleaker in the months ahead. "Suppose the economy turns out to be worse than the Great Depression," Mr. Arnott said. In that case, he said, "stocks fall in half again, but the bonds will hold up better." Why? As long as the bond issuer stays in business, you're likely to get generous payouts regardless of economic conditions. And should the company go under, you'll still recoup more of your assets than equity investors because bondholders enjoy preferential status under bankruptcy laws. This is only a tactical strategy based on current market conditions. Once the economy starts showing signs of real improvement - and as corporate bond spreads narrow - investors must reassess their appetite for risk and think about moving this ersatz allocation back into equities, Mr. Ankrim and Mr. Arnott said. Investors should also consider the risk in keeping too much of this money in corporate bonds for too long. Robert L. Rodriguez, chief executive of First Pacific Advisors and co-manager of the FPA New Income fund, warns that with all the monetary and fiscal stimulus being deployed, inflation is likely to make a significant comeback sometime within the next three to five years. And though many stock investors fear inflation, bondholders traditionally hate it even more. That's because rising prices can eat away at a greater portion of the modest returns that bonds typically deliver. So if investors are planning to rebalance into corporate bonds instead of stock, they should select a fixed-income manager who favors shorter-term securities. "Or, if you buy the bonds directly, keep your maturities no longer than about five years," Mr. Rodriguez said. "If I'm correct, and inflation is coming back," he said, "then you want to be defensive."
And when the cuts are on the scale of GE and Pfizer, the damage they do in the economy stretches across years. For shareholders who relied on that money, "it's a pay cut every year from now on," said Howard Silverblatt, index analyst at S&P in New York. We aren't just talking about the rich here. Plenty of average retirees down the wealth scale have long owned blue-chip, dividend-paying stocks as a way to generate regular -- and rising -- income. The good news is, many of those bets still are paying off as hoped: Although this may end up the biggest year for dividend cuts since the Great Depression, according to S&P, many firms are continuing to raise their payouts even in the face of the economy's woes. On Friday, consumer-products titan Colgate-Palmolive boosted its quarterly dividend to 44 cents a share from 40 cents, a 10% increase. Industrial products manufacturer ITT last week lifted its quarterly payout 21%, to 21.25 cents a share. In all, 45 companies in the S&P 500 have boosted dividends this year, outnumbering the 34 that have cut. Josh Peters, who tracks dividends for investment research firm Morningstar, offers an interesting proposition: Companies that stay committed to paying and increasing dividends could gain star status with investors in the years ahead. That would require that people think about stocks the way they were viewed in bygone eras: "You should look at a stock as a claim on the company's income, not as a growth vehicle," Peters says. Until the 1980s, dividends had long been a key focus for many investors as they shopped for stocks. That changed as the bull market charged ahead in the '80s and '90s, and as stock options rose to prominence as a form of compensation for managers. As investors and managers got used to huge recurring capital gains, dividends faded in importance for most stocks. Now, with the S&P 500 index back to levels last seen in 1996, capital gains are a distant memory. And it's becoming harder to imagine stock prices zooming again any time soon, even when the recession ends: With high debt levels likely to weigh on the economy for many years, the nation (and world) might at best expect a painfully slow recovery that keeps corporate earnings, and share prices, subdued. If that's what we're facing, the promise of growing dividends may well become a primary marketing tool for companies hoping to lure investors to their shares. For the moment, individual investors looking for income and relative safety are turning to corporate, municipal and government bonds. Purchases of bond mutual funds have surged this year. And investors who want to take no risk at all are staying in money market funds or bank accounts, where they're earning dismally low yields. Stocks can't offer that kind of safety. But with annualized dividend yields on many S&P 500 stocks exceeding 3%, that's a decent income return. More important, because dividends can grow over time, they offer a significant long-term advantage over bond interest, which is fixed for the life of the bond. And because Obama would keep the low 15% top tax on dividends for all but the wealthiest folks, dividends would maintain their tax advantage over bond income, which is taxed at ordinary rates. Investors will never give up hoping for capital gains from equities. But dividends -- at least when you can depend on them -- should become more appreciated as the proverbial bird in the hand.
Friday, finance professor Elroy Dimson of London Business School will publish his periodic update of long-term investment returns, which is eagerly awaited each year among the propeller-heads of the investing world. Along with his colleagues Paul Marsh and Mike Staunton, Prof. Dimson compiles vast amounts of reliable data on 17 stock markets around the world all the way back to 1900. Naturally, the report this year focuses on bear markets. The results shocked even me, and I don't startle easily. Consider this: Prof. Dimson estimates that we'll have to wait nine more years before the Dow average, including dividends, has a 50% chance of hitting its 2007 highs. The report also challenges the conventional wisdom that a run of bad results in the past must be followed by good returns in the future. Following the worst years, stocks outperformed cash over the next five years by an annual average of 7.1 percentage points. But after the best years, stocks outperformed by 6.8 percentage points annually -- a statistical dead heat. "If you were trying to find a rule buried in this as to what investors should do to make money," says Prof. Dimson, "it's kind of hopeless." The report hammers home another uncomfortable truth. The belief that stocks become virtually riskless if you just hold onto them long enough -- popularized a decade ago in books like Jeremy Siegel's "Stocks for the Long Run" and James Glassman and Kevin Hassett's "Dow 36,000" -- has been shattered by reality. No matter how long your investing horizon may be, the risk of owning risky assets can never go to zero. Since 1900, there have been four global bear markets in which stocks have fallen by at least 40%, adjusted for inflation. Two have occurred in the past nine years alone. Stocks are risky not merely because their returns are variable, but because they can wipe you out at various points along the way. That's the price you must pay -- often at the worst possible time, and never with a moment's notice -- for the hope of higher returns in the end. That hope is real and valid. It is also uncertain. "More people are realizing that equities are still risky even over long horizons," Prof. Dimson says. "So I think some of the reasons that people were willing to pay a high price for risky securities have been curtailed." It may be a long time before investors are again willing to value stocks at much higher than the long-term average of 15 times earnings. That's important. Expectations can be a major factor in stock valuations for years; you don't always get what you foresee. In 1900, for example, many investors were in a triumphal mood, buoyed by the trend toward peace and prosperity. But over the next five decades, all hell broke loose, and global stock markets returned an annual average of just 3.5% after inflation. In 1950, Cold War pessimism was the order of the day, and many doubted whether humanity itself would survive the years to come. But progress prevailed; global stock markets gained 9% a year, adjusted for inflation, over the next five decades. The mood today is probably closer to the pessimism of 1950 than to the optimism of 1900, which is itself a hopeful sign for the longer term. Nor are Prof. Dimson's findings quite as discouraging as they sound at first. If there's an even chance that the Dow will nearly double in nine years, that implies a total return of 7.1% per year, which isn't exactly chicken feed. Since 1900, U.S. stocks have averaged a 6% annual return after inflation. If you knew nothing else -- and none of us do -- then that should be your forecast of the return on U.S. stocks over the long term. That's measured in decades. In the short run, as just about every investor now realizes, anything can happen.
Those comparisons certainly make it sound as if stocks are incredibly cheap. But they aren't, at least not according to the price-earnings ratio. That ratio, a standard measure of market valuation, divides the average price of stock in the index by the earnings of the companies in the index. Based on the average earnings of companies over the past year, the current p-e ratio is about 30, far above the long-term historical average of 16. By this metric, stocks actually look expensive and may seem as if they still much further to fall. The problem with this metric, however, is that it's overly sensitive to economic swings. Corporate earnings are plunging now, because of the recession. P-E ratios always spike during recessions - and corporate earnings always recover, so many investors simply ignore short-term ratios during recessions. It makes more sense to look at earnings over a longer period of time, which smooths out the economic cycle. I have written before about a P-E ratio based on the previous 10 years of earnings, a measure favored by Robert Shiller, the author of "Irrational Exuberance," and others. By this measure, the P-E ratio of the S&P500 is now about 14.5. It's below average, but not enormously so. By comparison, this ratio fell to 6 during the 1930s and 7 during the early 1980s. In short, stocks are a little less expensive than their historical average. But they are far more expensive than they were at the worst points of the other two worst recessions of the past century. How could this be? The main answer is that stocks were incredibly expensive before the current crisis began - more expensive than at almost any other point in the last 100 years, save the bubbles of the 1920s and 1990s. They had a long way to fall. The fact that earnings are falling - and may well remain low for the next several years - doesn't help either. For the average investor, I would repeat the advice I offered in November: Stocks are definitely becoming cheaper. If you are a long-term investor, they may even be worth buying at this point. But they may still have a ways to fall. As per usual, thanks to Howard Silverblatt at S.&P., for providing valuable data.
Both of these fund categories now include foreign equities as well as domestic equities. But the world allocation funds, as their name suggests, typically hold more in international stocks. While the average world allocation fund has nearly 30% of its assets in international stocks, the average moderate allocation fund has only 10%. As a practical matter, it really didn't matter where you were invested in equities last year. The decline was global. There was no place to hide: Wherever they were, equities were taken out and shot. Unless you invested in government securities, you were likely to lose money in bonds as well. Investors in corporate or municipal bonds suffered losses. The real surprise here isn't that lazy and cheap investing did better than expensive active investing. I've been telling you that story, and documenting it, for decades. The real surprise is that bear markets are where lazy index investing is supposed to fail, while clever managed investing is supposed to succeed. But that didn't happen. The reason managed investing should beat index investing in a bear market has nothing to do with the supposed smarts of those on Wall Street. It has been painfully demonstrated that Wall Street is populated by witless greed freaks. Managed funds should beat index funds in a bear market because index funds are always fully invested, while managed funds hold some cash. As a consequence, managed funds have the advantage of some cash in a bear market and the disadvantage of, yes, some cash in a bull market. In other words, managed funds should have the benefit of dumb luck in bear markets. If there was ever a year to be holding cash, it was 2008. The domestic stock market lost 37%. The international markets lost 44%. In spite of that, our cheap, lazy and passive approach beat the average managed fund by 8 percentage points. In fairness, this isn't the whole story. The most basic Couch Potato portfolio is one part equities and one part fixed-income. That's 50% equities. (Other Couch Potato portfolios have up to 10 building blocks and can hold up to 80% equities. ) The typical moderate allocation fund is 60 percent equities. World allocation funds are about the same. In a devastating year like 2008, a 10 percent difference in equity allocation makes a big difference in performance. In fact, managed investing still fails when you compare it with the Couch Potato portfolios that have comparable equity allocations. The Five-Fold Couch Potato portfolio - built with 20% allocations to domestic equities, Treasury inflation-protected securities, international equities, international bonds and real estate investment trusts - has a 60% equity allocation. It lost 24.39% in 2008, easily beating the average moderate and world allocation funds. Ranked against these funds by percentile, the Five-Fold Couch Potato portfolio beat 70% of all world allocation funds and 79% of all moderate allocation funds. Couch Potato investing may not protect you from losing money, but at least you won't have to pay through the nose to do it.
With the stock market's volatility and fears over credit quality sending investors flocking to Treasurys, yields on government debt have dropped to their lowest level in a half-century, which in turn put pressure on fund managers to deliver yields in a reasonable range. Some have cut costs or waived fees, particularly money-market funds that might otherwise have "broken the buck," shrinking net asset values below the steady $1 level because expenses are greater than the interest the invested assets can earn. Others have closed the door to new investors; turning away new customers protects returns for current shareholders because managers don't have to buy as many new Treasurys with yields lower than current holdings. "A lot of people right now have gotten to where they are so risk-averse that they are willing to buy funds where they have no reason to believe there will be any real return," says fund manager Eric Kobren of Kobren Insight Management. "A year and a half ago - when people were getting paid absolutely nothing to take risk - everyone wanted to jump into high-yield stuff. "Today, when the spreads are huge and you could make money in many different types of bonds, nobody wants to look at anything but Treasurys. ... That picture will not straighten out for a while, and Treasury funds won't be too attractive again until it does," Kobren said. Treasury-oriented funds are a bit different from most other types of stock and bond funds. While they do not come with a guarantee that they will make money, the basic investment premise is pretty simple: Shareholders pool their resources, buy the most straightforward of securities, take the yield they can get, pay the freight on management fees and keep what's left as a profit. The value of the bonds may fluctuate - which can push net asset values down - but the long-term investment proposition is still as simple as "keep what's left after expenses." If yields drop so low that there is nothing left after costs, however, then Treasury funds have lost their raison d'être. At that point, an individual investor interested in Treasurys would be better off buying the bonds directly, avoiding the management fee, locking in the yield and protecting their principal.
While investors lost significant sums in every sector last year, they're finding some pockets of opportunity now, which could be a sign that pure panic is being wrung out of the market, and that fundamental factors for specific stocks and sectors are beginning to strongly influence investors' thinking once again. Under these circumstances, of course, short-term opportunity for an investor might mean eking out a tiny gain, or holding losses to a minimum. For example, mutual funds that concentrate on technology have gained 2% on average this year, according to Morningstar. Health care funds rose 3%, while energy funds lost 1% and utilities funds fell 3%. These are all much better performances than the decline of more than 8% in the Standard & Poor's 500-stock index this year. What do these four sectors have in common? They all enjoyed year-over-year profit gains in 2008. Though overall earnings for companies in the S&P500 contracted by an estimated 12% last year, energy and health care earnings grew 21% and 7%, respectively, according to consensus estimates compiled by Thomson Financial. Profits among utilities in the S&P500 grew an estimated 3%, while technology company earnings expanded by 2% in 2008. Telecommunications was the only other sector for which earnings grew. Funds that specialize in those stocks are down roughly half as much as the S&P500 this year. It would be premature to conclude that panic selling has ended and that fundamental factors are now the main determinant of stock prices. But James W. Paulsen, chief investment strategist for Wells Capital Management in Minneapolis, said, "To the extent that this shows some semblance that fundamentals are starting to matter again, that's a good thing." It is striking, for example, that the best-performing sector of the S&P this year has been technology, an economically sensitive group that isn't expected to do well in the midst of a recession. Yet shares of tech stocks like Micron Technology, Western Digital and Sun Microsystems have surged more than 35% in less than two months. Mr. Paulsen noted that the relative strength of tech shares may be a sign that investors are weighing earnings and stock valuations, and not making all of their decisions on the basis of macroeconomic issues. This appears to apply to bonds as well as stocks, he said, and might explain why the spread in yields between ultra-safe Treasuries and riskier corporate debt has narrowed this year, as investors have started to gravitate toward cheaper and potentially more rewarding securities. Of course, none of this means that the market's troubles are over. "It's still kind of a crap shoot," said Alec B. Young, an S&P equity strategist. For example, he said, "If investors don't feel like there's a credible stimulus package in the works and a credible fix for the financial markets, then they will assume the recovery won't take place until possibly 2010." Concern about the state of the financial markets might explain last Tuesday's 382-point drop in the Dow, which occurred when market strategists and economists complained of the lack of specificity in the bank rescue plan presented by the Treasury secretary, Timothy F. Geithner. Similarly, if it starts to seem that 2009 earnings will be disappointing, that too could cause stocks to lose further ground. Currently, Wall Street is bracing for a 14% decline in 2009 earnings, versus 2008. That target assumes a 21% increase in financial sector earnings. If bank and broker profits don't recover, overall corporate earnings could sink much more than is now expected. In short, Mr. Young said, focusing on fundamental factors will take you only so far. The good news, he said, is that "parts of the market seem to have found solid ground." And the bad news? If investors don't see actual evidence of a global recovery on the horizon, another rocky year could be in store for the stock market.
So it is with no small dose of trepidation that I explore the possibility that U.S. Treasuries are incredibly overpriced, which of course is just another way of saying that their yields are way too low. But if they are, then investors should run, not walk, away from placing any long-term bets in U.S. Treasuries. Instead, consider the alternative investments that I describe below. Right now the yield on the 10-year Treasury note stands at 2.89%. On an after-tax basis for an investor in the highest tax bracket, that translates into an effective yield of 1.88%. In order for such an investor to show any real (after-inflation) return over the next 10 years, inflation therefore would have to average less than 1.88% for the next decade. What are the chances of that? Even if you are investing in a tax-free account, what are the odds that inflation for the next decade will average less than 2.89%? While you're mulling over your answer to these questions, consider the following: In July 2007, the 10-year Treasury note was yielding 5.2%. In other words, despite the federal government injecting trillions of new dollars into the financial system over the last 18 months, in a textbook illustration of the monetary inflation for which Federal Reserve Chairman Ben Bernanke earned his nickname of "Helicopter Ben," the markets are nevertheless discounting a much lower inflation rate today than then. Or consider this mathematical truth about the power of compounding. Let's assume that the inflation is negative for the next two years, at a rate of (negative) 2% a year. That's deflation, in other words. That's a big assumption, since Helicopter Ben has dedicated himself to never allow the economy to slip into deflation. But let's nevertheless assume that we get a 2% deflation for each of the next two years. Let's further assume that for the eight years thereafter that consumer prices actually grow and the inflation rate is 5% a year. That seems reasonable given how much money would be injected into the economy if we actually get a sustained deflation -- money that presumably will eventually translate into higher inflation. Given these assumptions, the inflation rate over the next 10 years will still average 3.6% a year. That's more or less twice the 1.88% after-tax current yield of the 10-year Treasury note. To be sure, we can endlessly play around with these assumptions. But the general idea is clear: Locking in Treasuries' current yields provides a long-term real return only if inflation is a whole lot lower than what it seems quite clear it will be. How did the markets get into this situation? The obvious answer: panicked investors' flight to quality over the last 18 months. Investors have been so concerned about the credit quality of any borrower other than Uncle Sam that they have been willing to forfeit much, if not all, of their yield. It's not that investors during this flight to quality reduced their expectations of future inflation. It's instead that in their panic they became preoccupied with the safety of their principal. Unless the world comes to an end, however, this credit and liquidity crisis won't last forever. And when it does dissipate, Treasury yields will once again reflect investors' expectations of future inflation. You don't have to be a market timer and try to predict when this will begin to happen to know that -- absent the end of the world -- it will take place eventually. In many ways, the current situation is just the inverse of what prevailed in 1981, when the yield on the 10-year Treasury climbed above the 15% level. That meant that investors were betting that average inflation for the subsequent decade would be close to double digits. That in effect meant that investors were betting on the financial equivalent of the end of the world, since double-digit inflation for 10 years in a row would have been nothing short of devastating. It took courage at that time to follow the contrarian conclusion and buy Treasuries. But there were at least some who did: The editor of one of the investment newsletters I monitor told me that he put his daughter through Yale on the profits he earned from buying Treasuries at that time. What would the corresponding contrarian strategy be in today's yield environment? The particularly risky bet would be to sell Treasuries short. If you want to be that aggressive, the preferred vehicle for doing so would be an exchange-traded fund, such as the iShares Barclays 10-20 Year Treasury Bond Fund (ticker: TLH). Be aware that, even if you eventually turn a big profit on this trade -- which I believe is likely, of course -- you still will have a not-insignificant carrying cost during the trade, in the form of the dividends that the ETF pays along the way. A conservative way of making the contrarian bet today is simply to invest in TIPS, the Treasury securities that are indexed against the consumer-price index and which therefore provide a guaranteed return above and beyond inflation. An ETF that invests in TIPS is the iShares Barclays TIPS Bond Fund (TIP). A contrarian trade whose riskiness is in-between the conservative TIPS strategy and the aggressive short-sale would be to create a hedge that buys TIPS and sells short an equivalent dollar amount of regular (nominal) Treasuries. Such a hedge will show a profit so long as nominal Treasury yields rise faster than do TIPS yields -- or fall less than TIPS yields do if yields unexpectedly continue to fall.
These makeover opportunities, of course, are a consequence of losses practically everywhere you turn. No one wanted this carnage to happen, but now that it has, here are two ways to make something useful out of it: "There's no better time to diversify than when everything is down," Mr. Scarborough said. A prime example is foreign stocks. He noted that before this downturn, when overseas stocks were soaring, risk-averse investors faced a quandary. "You could either diversify knowing full well that you were paying high prices, or you could forgo that exposure, which meant that you might be adding volatility to your portfolio over the long run," he said. "This conundrum no longer exists," he added, because stocks overseas have sunk even more than domestic shares, bringing the foreign valuations down to earth. The price-to-earnings ratio for foreign stocks in developed markets has tumbled to around 10, on average, from nearly 14 near the market's peak in 2007, according to Standard & Poor's Equity Research. (This is based on consensus forecast earnings for the coming 12 months.) P/E ratios for emerging-markets stocks have fallen even more - to 8.5 from 14.5 near the peak. Because valuations globally have come down significantly, said Alec B. Young, an S.& P. equity strategist, "this is a much better time to be looking at these markets." Despite all the attention on international markets earlier in this decade, most individual investors still have only slim stakes abroad. According to figures tracked by Hewitt Associates, 12 percent of the equity portfolio of the typical 401(k) investor is in foreign shares. That's about half the level that many planners recommend. Real estate investment trusts are another example of once-frothy assets that have fallen significantly - and that can be used for diversification. Over the last 20 years, investors would have slightly improved performance and reduced volatility by shifting 10% of their equity stake into REITs, according to Morningstar. Yet it was hard to justify moving to REITs earlier this decade, when Wall Street was euphoric about them. REITs have fallen more than 40% over the past year, on average, and while they still pose significant risks in a recession and real estate downturn, they may be worth a closer look. For years, investors have been told that a simple way to bolster long-term performance is to invest through low-cost mutual funds or exchange-traded funds because fund expenses reduce returns dollar for dollar. But it hasn't always been that simple for older investors to replace their holdings with less expensive funds. That's because it means selling your existing funds, potentially setting off capital gains taxes. The sharp decline in the stock market has taken care of much of that problem. Although there are exceptions, it's likely that market losses will mean lower capital gains taxes if you sell your holdings now, said Stuart L. Ritter, a financial planner at T. Rowe Price. Over the past decade through Thursday, 52% of all domestic stock funds and 77% of all large-capitalization stock funds have lost money, according to Morningstar. And some losses have been substantial. Consider Putnam Growth Opportunities. This fund is down 7.3% a year, on average, for that period. Mutual fund losses are even more widespread over the past five years: 91% of all domestic stock funds fell during this period. So if you bought high-cost funds, you will likely be able to sell them with little or no tax consequence and move into low-cost alternatives. This strategy even works for investors already in reasonably inexpensive funds. Say you're now in a large-cap fund like Vanguard U.S. Growth; its annual expense is a modest 0.43%. But because this fund is down over the past decade, you might easily sell it - capturing the tax loss, which can be used to offset gains or up to $3,000 in ordinary income - then swap into a cheaper option like an index fund that tracks the S&P500. Examples are Vanguard 500 Index, which charges 0.15% annually, and Fidelity Spartan 500, 0.10%. You might also consider E.T.F.'s tracking the broad market - like iShares S&P500, at 0.09%. Buying and selling E.T.F. shares, however, requires brokerage commissions. So investors who wish to put small amounts to work every month or quarter may want to consider a traditional index fund or actively managed portfolio that doesn't charge sales commissions. "It's pretty obvious that there are a lot of opportunities in this market," Mr. Scarborough said. The key is not to delay so long that the markets begin to recover, closing this window of opportunity.
These are the surprising implications of a fascinating study published Thursday by Ned Davis Research. Pat Tschosik, a senior equity analyst at the firm, took a sober and data-driven look in comparing the popping of the financial sector's bubble over the last 18 months compares to the bust of the Internet bubble in 2000-2002. In several significant ways, believe it or not, the tech experience early this decade was even more traumatic than what has transpired since mid-2007. Since its peak in 2007, for example, the financial stocks in the S&P 500 index have dropped 78.7% - slightly less than the 82.5% by which the information technology stocks in that index dropped in the 2000-2002 bear market. Not so fast, you might object: Surely the financials in 2007 constituted a more important sector than technology did in 2000, right? Not necessarily. According to Tschosik, the information technology sector represented about 35% of the S&P 500 at its March 2000 peak, in contrast to the 22% weight that the financials sector represented at its peak in 2007. As a result, a greater amount of total market capitalization was destroyed by the tech sector's decline in the 2000-2002 bear market ($3.6 trillion) than by the financial sector's decline since 2007 ($2.2 trillion). To be sure, these historical comparisons provide little solace to investors who have lost huge amounts over the last 18 months. But they do provide a reality check on excessive pessimism and despair. Just as it's dangerous at the top of a bull market to think that "this time is different" -- and that the old rules no longer apply -- the same is true when we're at the depths of a bear market. Just as trees don't grow to the sky, as John Maynard Keynes famously once remarked, those trees' roots won't continue descending until they get to China either.
"A lot of people rely on those dividends for income," said Tim Ghriskey, who helps oversee $2 billion as chief investment officer for Solaris Asset Management LLC. "If the economy continues to deteriorate, we're going to see more cuts, and it's going to hurt them even more." An investor owning the S&P 500 who pocketed the average dividend paid by its companies in 2008 would have lost 36% last year, compared with a 38.5% decline for the index itself. That's the biggest difference in at least 16 years, according to data compiled by Bloomberg. The number of S&P 500 companies reducing shareholder payments climbed for five straight months to 53 in November, the last period for which data is available, S&P said. That's the most since records began in 1956. Investors may have to wait before payouts rebound. Dividends are a lagging indicator of financial health and can take a year to recover once the economy stops shrinking, said Dirk van Dijk, research director at Zacks Investment Research in Chicago. "If you're a trucking company, your first priority isn't to raise the dividend," van Dijk said. "It's to replace the truck that's leaking oil." Companies in the S&P 500 cut $40.6 billion in payouts last year after a five-quarter profit slump lowered cash reserves, according to S&P data. More than 90 percent of the reductions were by financial companies. The percentage of profits returned to shareholders rose to a seven-year high of 63 percent at the end of 2008, leaving 23 companies paying more than they earned in the last year, according to data compiled by Bloomberg. Earnings among S&P 500 companies are expected to fall 28 percent in the fourth quarter, with declines across each of the 10 industry segments, according to analyst estimates compiled by Bloomberg. For 2008, S&P 500 companies probably earned a combined $44.91 a share before one-time items, a profit measure that gauges the ability to pay a dividend, according to data and estimates compiled by Bloomberg. That's down from $73.01 in 2007. How Fund Categories Fared WSJ 1-05-2009
But one could also argue that investors made things worse by adhering to some conventional wisdom rooted in the bull markets of the past quarter-century. And some of those ideas may have run their course. To be sure, even the most experienced and skilled investors found few places to hide in this market sell-off. In fact, since the bear market officially began on Oct. 9, 2007, almost all kinds of investment - domestic stocks, foreign equities, commodities, real estate and even many types of bonds - were slammed. And in this harsh climate on Wall Street, investors may need to rethink some of their basic assumptions about certain asset classes and diversification. Here's what investors have already found out the hard way: Losses Can Be Long Term Stocks can lose money, even for a decade. Anyone who was around during the bursting of the technology stock bubble in 2000 knows how much and how fast stocks can fall in a bear market. Yet even after that debacle, many clung to the belief that as long as they had a long-enough investing horizon - say, a decade - they would always come out ahead by being aggressive. Well, the current market slide has all but erased that thinking. It's been about nine years since the tech wreck, and the S&P 500 remains 39% down from its peak back then. (That's not including dividends.) Sam Stovall, S&P's chief investment strategist, says investors must surely be wondering how long the holding period must now be for this faith in stocks to hold true. "One thing I do know is that it's not 10 years," he said. So what is the new answer? Looking ahead, investors need to understand that it could take as long as 20 years for stocks to recover fully from major downturns in a worst case. So investors who are nearing retirement - and don't have that much time to recover from market losses - need to think twice about putting all or virtually all of their portfolios into stocks. Remember that the S&P500, on a price basis, went pretty much nowhere in the 16-year span from 1966 to 1982. And after the stock market crash of 1929, it wasn't until 1947 that stocks started to surge for good, Mr. Stovall noted. Stocks Aren't The Only Game Diversification means owning different assets, not just different stocks. When virtually every type of equity was climbing a few years ago, investors were willing to "diversify" their stock portfolios - but not through different investments like bonds. Rather, they sought to diversify by buying different types of stocks, particularly those that were soaring - in emerging markets, for example. Aggressive investors argued that by adding emerging-market shares to a portfolio of domestic blue chips, they could derive a degree of diversification. And that is statistically true. What they didn't realize - but have since found out - is that emerging-market stocks can't shield a portfolio from losses if the broad market starts to fall. Only bonds can do that. And, in fact, during this downturn, only ultrasafe Treasury bonds accomplished this feat. Not only did emerging-market stocks fall more than domestic equities in 2008 - the MSCI Emerging Markets index fell 54%, versus the 38% drop for the S&P - they lost their diversification power as well. In the two months leading up to November, the correlation between the emerging-markets index and domestic stocks jumped to 81% from 68%, according to S.& P., as investors fled equities and moved to bonds. Long Live Treasuries There's an argument for owning Treasuries at all times, even though some investors have argued during the present downturn that they can find far more attractive yields through other investments. For example, the list of securities paying more than 10-year Treasury notes includes long-term corporate bonds, municipal debt, high-yielding junk bonds and even stocks. The yield on the S&P500 is now 3%, versus the 2.4% for 10-year Treasuries. Moreover, this argument goes, for those who are thinking of putting new money to work in bonds, there's a strong case that there are better values in these other fixed-income securities than in Treasuries. But investors who are considering selling their long-term Treasury holdings to take advantage of these other opportunities should think twice. Only those who own Treasuries for current income need to worry if their government bonds are offering the market-leading yields. For long-term growth-oriented investors, the primary role of Treasuries is to provide ballast and protection to a portfolio - not capital appreciation. That's what stocks are for. And as this bear has shown, no investment can beat Treasury bonds when it comes to protecting one's portfolio in a downturn. In 2008, for example, the average long-term government bond fund returned more than 27%, as frightened investors drove up the value of Treasuries. Almost every other bond fund category fell last year along with stocks - as fears about the credit market gripped Wall Street. "When you have a real crisis, there tends to be a flight to quality," said Ned Notzon, the chairman of the asset allocation committee at T. Rowe Price. "And the one sector that will do extremely well in such a market will be Treasury bonds."
Might there be a silver lining in these historical statistics? Does the stock market tend to bounce back after losses as big as 2008's? Unfortunately not. That, at least, is the conclusion I reached after feeding the Dow's yearly returns into my PC's statistical package. Try as I might to find year-to-year patterns in the data, I came up empty: Whether or not the Dow gains or loses in a given year has little to do with whether it gained or lost in the previous year. In other words, the stock market sometimes does bounce back after having a bad year. But on other occasions it continues to go down. Consider 1908 -- the year after the Dow lost 37.7% -- when it gained 46.6%. Not bad. But before you get too excited, consider how the Dow did in 1932, the year following its 53.7% loss in 1931. In 1932, the Dow lost an additional 23.1%. Two data points aren't conclusive, to be sure. But upon analyzing all 112 yearly returns, I failed to find any correlations in the year-to-year returns that were statistically significant. The bottom line? We can draw very few inferences about 2009 from the stock market's terrible performance in 2008. Whether you consider this to be good news depends on whether you are inclined to see the glass as half-full or half-empty. Even though the stock market doesn't automatically bounce back after terrible years, an additional bad year isn't preordained, either.
-38.49% The percentage loss in the S&P 500, worst since 1937. -40.54% The percentage loss for the Nasdaq Composite Index, worst in history. 126 The number of up days on the S&P 500 in 2008. 126 The number of down days on the S&P 500 in 2008. (The difference, of course, is that on the down days, the market lost an average of a kajillion points.) 28 The number of Dow industrials components ending lower on the year. The outliers were Wal-Mart Stores and McDonald's. 15 The number of Standard & Poor's 500-stock index members that ended the year in positive territory. This is the worst breadth for the S&P going back to 1980; second-worst was 2002, when 131 stocks, or 26% of the issues, rose on the year. 18 The number of daily 5%+ moves on the S&P 500 in 2008. 17 The number of 5%+ moves on the S&P 500 between 1956 and 2007. Quick Facts, Stats & Opinions Normally, we expect society to progress, amassing deeper scientific understanding and basic facts every year. Knowledge only increases, right? Robert Proctor doesn't think so. A historian of science at Stanford, Proctor points out that when it comes to many contentious subjects, our usual relationship to information is reversed: Ignorance increases. He has developed a word inspired by this trend: agnotology. Derived from the Greek root agnosis, it is "the study of culturally constructed ignorance." As Proctor argues, when society doesn't know something, it's often because special interests work hard to create confusion. Anti-Obama groups likely spent millions insisting he's a Muslim; church groups have shelled out even more pushing creationism. The oil and auto industries carefully seed doubt about the causes of global warming. And when the dust settles, society knows less than it did before. "People always assume that if someone doesn't know something, it's because they haven't paid attention or haven't yet figured it out," Proctor says. "But ignorance also comes from people literally suppressing truth-or drowning it out-or trying to make it so confusing that people stop caring about what's true and what's not." (Clive Thompson, Wired 1-19) From James Grant's in "Mr. Market Miscalculates" - As a rule, investors see what they want to see. Therein lies the allure of the irrational Mr. Market, a character invented in the 1930s by the father of value investing, Benjamin Graham. Mr. Grant follows Graham in insisting that Mr. Market's herd behavior - "price is never an object; he just wants in, or he wants out" - creates opportunity for a disciplined investor to find stocks selling at a discount to a company's intrinsic value. Panicked investors will care no more about value than the euphoric ones did. But here's the paradox of successful "value investing": it's possible, if at all, only because few practice it. (Stephen Kotkin, NY Times 1-03) Home Page Previous Factoid Top Sites
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