FREE NEWSLETTER

No Alternative

Jonathan Clements  |  May 9, 2020

IT’S A SCARY TIME to own stocks. But for long-term investors who want their portfolio to clock significant gains, there’s simply no alternative.

To be sure, you could throw in your lot with the market-timing crowd, who are currently hiding out in bonds and cash investments. Their plan: When we get the final climactic plunge in share prices that sends the market back to valuations not seen in four decades, they’ll swap into stocks and ride the next bull market to astonishing wealth.

But for the rest of us—who don’t have nearly as active a fantasy life—the best bet is to hang tough in stocks with the bulk of our long-term investment money. Why? Consider the three major asset classes.

Bonds pay nothing. When you buy a bond or bond fund, the best guide to your likely return is the current yield. Just purchased a 10-year Treasury note yielding 0.7%? If you sell before maturity, you might make more or less than 0.7% a year. Still, that 0.7% is the best guide to your future return.

If you opt for bonds of lower credit quality, you’ll get higher yields and that should translate to higher returns. But there’s also an increased risk of defaults, especially if you dabble in bonds deemed below investment grade.

Bond yields should bear some relationship to nominal GDP growth. Why? Corporations will only borrow if they think they can earn a return that’s greater than the interest rate they pay—and that return should, on average, bear some relationship to the rate of economic growth. As the economy recovers, so too will demand for borrowed money and that’ll likely drive interest rates higher.

Those higher interest rates will push down the price of existing bonds, so today’s bond investors could be in for a rough ride as the economy recovers. But it isn’t all gloom: Bond holders will be able to reinvest their interest payments, as well as any new savings, at those higher interest rates. Indeed, if your time horizon is similar or longer than your bond portfolio’s duration, rising interest rates should bolster your long-run return, thanks to that chance to reinvest at higher yields.

Cash is trash. While bond yields tend to track nominal economic growth, the yield on cash investments is more closely tied to inflation—or, at least, inflation as anticipated by the Federal Reserve. And right now, the Fed has no worries about inflation. Instead, its focus is on reviving the economy, which is why the Fed has cut short-term interest rates pretty much to zero.

That means minimal returns on savings accounts, money market funds and other cash investments. What about longer-term inflation? Based on the difference between the yield on 10-year Treasury notes and that on 10-year inflation-indexed Treasurys, investors expect around 1% annual inflation over the next 10 years. That’ll mean continued meager returns for cash investors.

Still, that shouldn’t surprise anyone. Even when yields on cash investments have been much higher, investors have almost always ended up losing money, once inflation and taxes have taken their toll.

Stocks for the long run. What will stocks return? I fall back on the admirably simple method favored by Vanguard Group founder John Bogle. To forecast the stock market’s “investment” return, Jack would add the S&P 500’s current dividend yield to expected growth in earnings per share.

Right now, the S&P 500 is yielding 2.1%. Meanwhile, over the next 10 years, nominal GDP might climb 4% a year—that’s what we got over the past 10 years—and it would be reasonable to assume that earnings per share will increase at a similar rate. Add those two together and we’d get the S&P 500 clocking just over 6% a year over the next decade.

To this “investment” return, we need to consider a third factor—what Jack called the market’s “speculative” return, as reflected in the rise or fall in the S&P 500’s price-earnings (P/E) multiple. Guessing what will happen to the market’s P/E ratio is always a dicey endeavor, and it’s especially dicey right now.

It isn’t just that investors seem to be terrified one moment and exuberant the next. On top of that, we’re likely to see P/E ratios soar in the short term, as the economic contraction slams corporate profits. We could also see significant dividend cuts. The key is to look beyond this short-term chaos and focus on the decade ahead. And if we do that, I think it’s reasonable to expect something close to that 6% a year investment return.

Could stocks also get a lift from rising P/E ratios? It’s possible. Today, the S&P 500 companies are trading at 21 times 2019’s reported earnings. That compares to a 50-year average P/E ratio of 19.4 times trailing 12-month reported earnings and a 25-year average of 25.1. But even without rising P/Es, notching 6% a year looks pretty attractive when you consider the alternative—next to nothing on both bonds and cash investments. Convinced? Keep these three points in mind:

  • Even if stocks are the best bet for the decade ahead, don’t ignore your risk tolerance and your near-term need for cash. Bailing out of stocks at the wrong time could devastate your wealth.
  • Stocks may deliver 6% a year, but your return might be far different—if you aren’t diversified. And the best way to get that broad diversification is (here he goes again) by owning a total U.S. stock market index fund and a total international stock market index fund or, alternatively, by purchasing a total world stock market index fund, such as those offered by State Street’s SPDR and Vanguard Group.
  • If you buy total market funds, you’ll enjoy rock-bottom annual investment costs. But don’t forget about the other big subtraction: taxes. With that in mind, trade sparingly in your taxable account, so you don’t trigger big capital gains tax bills, and make the most of the retirement accounts available to you.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include We Need to TalkTake It Away and Back to Basics.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our weekly newsletter? Sign up now.

Subscribe
Notify of
6 Comments
Inline Feedbacks
View all comments
PAUL  ADLER
PAUL ADLER
1 year ago

What does the term time horizon or long term mean for a buy and hold investor that is 75 or 85 years old? How long is ones time horizon if they are 75 or 85 years old?

JDC MN
JDC MN
1 year ago

I’ve always joined those who would scoff at the suggestion that this time it is different. I’m not scoffing now. The market is now buying into the groundless optimism. How long can that last?

Bill Bengen
Bill Bengen
1 year ago

Jonathan, I have to admit, in my investment stance I am a lot closer to the “market-timer” crowd than you are. But I might be completely wrong, and you might be the right one. Actually, I would be happy to buy stocks if they attained the valuations of March 2009, not forty years ago. At a Shiller P/E of 13, I would probably allocate almost 100% to dividend-paying stocks, as they would be yielding 5% (or higher) and provide a better quality of income (increasing with inflation) than would bonds. There we agree! From these levels of valuation, I don’t believe investors have ever shown a profit in their stocks over a five to ten-year period. But who know what magic a crazy Fed can conjure up? Keep up the great work!

Langston Holland
Langston Holland
1 year ago

IMO, this is one of the most important investment articles you’ll ever read. It is an extreme distillation of everything an investor needs to know. Follow the rabbit trails as far as you like from any of its topics, but this is the big picture.

Some assumptions: you are in this long-term, you trust math more than emotion, you know both your risk capacity and risk tolerance, and you live below your means enough to have discretionary funds to invest.

Mike
Mike
1 year ago

Can someone explain this to me? I feel stupid.

“Based on the difference between the yield on 10-year Treasury notes and that on 10-year inflation-indexed Treasurys, investors expect around 1% annual inflation
over the next 10 years.”

Richard Gore
Richard Gore
1 year ago

As Niels Bohr famously said “It is very hard to predict, especially the future.” Earnings may evaporate and dividends aren’t obligations. Future stock returns are not guaranteed. It may be that future stock returns will be much closer to current bond yields than we may wish. I agree that we shouldn’t try to time the market, but it may also be prudent to maintain ample reserves.

Free Newsletter

SHARE