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Judy Loy: What is Next for Equities?

by on April 08, 2012 6:00 AM

Using the S&P 500 as a surrogate for the U.S. stock market and taking into account dividend reinvestment and inflation over the past 10 years to the end of Dec. 31, 2011, the real return of the S&P 500 was .29 percent (Doug Short, “Total Return Roller Coaster”).

Since there is no way to directly invest in an index, let’s say you purchased an inexpensive index fund, such as Vanguard 500 Index Fund Admiral Shares (VFIAX).  From 2002 through 2011 the 10-year return was 2.91 percent.

What does this mean? 

To clarify, let’s start with the make-up of the S&P 500.  S&P 500 is considered a gauge of the large cap U.S. equities or stocks and consists of 500 companies.  The index is market weighted so larger companies count more in the index.

The top five companies in the S&P 500 are Apple (AAPL), Exxon Mobil Corp. (XOM), International Business Machines Corp (IBM), Microsoft (MSFT) and General Electric (GE).  An index is fairly static but is updated when changes in market capitalization (market price of the security multiplied by outstanding shares) and decided on by committee.  When articles or newscasters speak of the U.S. stock market as a whole, they are typically quoting information on the S&P 500.  For U.S. money managers, beating the S&P 500 is the Holy Grail of investment success. 

Going back to our first paragraph, the S&P 500’s returns have been subpar throughout the last decade.  Since 1927 to the end of 2011, the average 10-year annualized return for the S&P 500 is nearly 11 percent, so 2.92 percent for the 10 years ending Dec. 31, 2011 is significantly below average.

Mutual Fund Company American Funds looked at previous 10-year periods that delivered below average annual total returns since 1937.  The 10-year spans were Aug. 31, 1929 to Aug. 31, 1939, which returned -5.03 percent, and Sept. 30, 1964 to Sept. 30, 1974, which returned .49 percent.

The key takeaway here is what happened after the 10-year under-performance.  In both these instances, the ensuing 10-year returns averaged 15.38 percent and 15.73 percent, respectively, over the next 20 years.  As the typical disclaimer goes, past performance does not guarantee future results.  There is also the old Mark Twain quote, “History doesn’t repeat itself-at best it rhymes.”

Another bullish viewpoint was issued in a Global Strategy Paper No. 4 on March 21, 2012 by Goldman Sachs’ Equity Strategists, Peter Oppenheimer and Matthieu Walterspiler in their paper titled, “The Long Good Buy; the Case for Equities.”

It makes a similar case by comparing historical returns and risk premiums for equities (stocks) and bonds (fixed income).  Instead of using Price to Earnings ratio (PE) to decide on valuation for stocks, Oppenheimer and Walterspiler argue that Equity Risk Premium is a better measurement of true valuation.

To begin this conversation, it is vital to understand Equity Risk Premium (ERP).  ERP is the excess return that the overall stock market provides over the risk-free rate.  The risk free-rate is usually the rate on long-term government bonds.  It is a basic idea of risk and return:  Because equities have greater volatility and risk, they should return more over time to compensate the holder for the increased risk.

However, the paper states, “While equities have achieved a strong premium for risk over long periods, this has not been true since the late 1990s.”  The hypothesis is that the reward for holding riskier assets (in this case, equities) will return.  It also reiterates American Funds’ data stating, “That the last few years have seen the worst real returns in US equities (along with the 1970s) in over 100 years.”  Comparing these returns to the real returns on bonds leads to an even more striking difference.  Overall, the paper makes a sound case. 

It is always a good idea to take any opinion on the future of the equity or bond markets with a grain of salt.  If we all had crystal balls or Magic Eight Balls that worked, returns and investments would be an easy way to make a quick buck.

That being said, when I hear the bears talking about the death of equities and ”this time it is different,” it harkens back to the many times I have heard it in my 20 years as an advisor.  For instance, when the huge tech bubble occurred in the late 1990s, the idea was that the Internet and explosion in technology had changed everything. So it followed that sky-high price to earnings ratios and endless positive equity returns were a given.

Then the bubble burst, just like all the times before.  The recent mistaken idea that real estate values would never go down is no more misguided than the present idea that equities will not go up.  My argument is that we need to know the history, stay diversified and know that maybe, just maybe, this time it’s not different.    

As a side note, please join Dan Nestlerode and me to celebrate Nestlerode & Loy’s 75th year in business at Nestlerode & Loy, Inc.’s CBICC Business after Hours on April 12, 2012 at Centre Hills Country Club.  More information can be found at www.cbicc.org.

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Judy Loy, ChFCâ, is a Registered Investment Advisor and CEO at Nestlerode & Loy Investment Advisors, State College, Pa. A graduate of Penn State University, Loy has been with the firm since 1992, assisting clients with retirement planning, brokerage services and investment advice. She can be reached at jloy@nestlerode.com.
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