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Asset No. 1: Stocks

STOCKS WERE A GREAT investment over the past century, but miserable performers between early 2000 and early 2009. What can we expect in future? Nobody knows. But for stock investors, there’s reason for both optimism and caution.

U.S. stocks have barely outperformed U.S. bonds over the past 18 years. But that shouldn’t persist. Stocks are riskier than bonds, so they should be priced to deliver higher returns. When you buy a stock, you become an owner, with the prospect of endless gains if things go well and the possibility of losing everything if they don’t. Meanwhile, as a bond investor, you are merely a lender, with limited upside—represented by the yield—but also less risk. If a company gets into difficulty, its bondholders will be paid off before stock investors receive anything. The bottom line: If stocks didn’t hold out the prospect of higher returns, people would be crazy to buy them (which, in retrospect, was true in early 2000).

But it isn’t just that investors demand a higher return when they buy a risky asset like stocks. Corporations should also supply it. As the economy grows, corporate earnings ought to climb, and shareholders may also collect dividends. By contrast, with bonds, overall yields shouldn’t be greater than the growth rate of nominal gross domestic product—and right now they’re below the GDP growth rate. That suggests bond investors will earn modest returns, and they could see bond prices tumble if interest rates rise.

While the long-term outlook may be brighter for stocks than for bonds, there’s one caveat and one wildcard. The caveat: The full benefit of economic growth won’t necessarily flow through to shareholders. Earnings per share may not match the economic growth rate, which means share price gains could lag behind GDP. And then there’s the wildcard: What value will investors put on corporate earnings and dividends? The fact is, today, U.S. stocks aren’t cheap.

Next: Inflation

Previous: Where We Stand: Valuations

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