Traders work on the floor of the New York Stock Exchange
The facts tell the dismal story. In the 10 years ending Dec. 31, 2008, investors suffered a negative 3.15% real return in U.S. stocks, constituting the fourth worst 10-year period since 1871. Given the pummeling the stock market has taken this decade — even after this year's rally, the S&P 500 index remains 32% below its all-time high reached in October 2007 — many are now questioning whether stocks should be the cornerstone of investors' long-run portfolios.
But history shows that excellent returns are available to stockholders who survive such rough patches. In fact, following the 13 10-year periods of negative returns stocks have suffered since 1871, real returns over the next 10 years have never been negative and have averaged more than 10% per year. A 10% return far exceeds the stock market's long-term average real return of 6.6% and is more than three times the real return offered by U.S. Treasury bonds. Furthermore, stocks have always done better than bonds over every 30-year period since 1871.
Skeptics claim that statistics such as these are biased in favor of equities because they are derived solely from long-term U.S. data. But the excellent historical returns of stocks are not limited to the U.S. Three U.K. economists — Elroy Dimson, Paul Marsh and Mike Staunton — have examined the historical stock and bond returns from 16 countries since 1901 and published their research in a book entitled Triumph of the Optimists: 101 Years of Global Investment Returns. Despite wars, bouts of hyperinflation and depressions, stock investors in all 16 countries examined enjoyed high returns that outpaced fixed-income assets.
Equities bears maintain that the recent stock rally has already outrun fundamentals and that stocks are no longer cheap. To be sure, based on projected operating earnings for all of 2009, S&P 500 companies are trading at an average price-earnings ratio of nearly 19, higher than the long-term historical average of 15. But basing stock values on 2009 data is inappropriate. This year saw the bottom of the worst recession since World War II. What is relevant for determining stock values are future earnings, not past earnings. Next year's operating earnings for S&P 500 companies are projected to average $74 a share, less than 15 times earnings; early estimates for 2011 are at $85 a share, 12.5 times earnings. Indications are that stocks have room to run, especially when interest rates and inflation are factored in. My research shows that when inflation and interest rates are low, as they are today, stocks sell on average at 18 to 20 times earnings, substantially higher premiums than current levels.
Bill Gross, the head of PIMCO, has joined other bears by claiming the U.S. economy is entering a "new normal" era of slower economic growth and limited stock returns because American consumers have become thriftier. Instead of spending, they are paying off their heavy debts, and this will weigh on corporate earnings indefinitely. Yet it is world economic growth, not U.S. growth, that will dictate future stock returns. S&P 500 companies now obtain almost half of their revenue and profits outside the U.S. That share will most certainly rise as growth in the emerging nations continues to outpace that of the developed world.
Furthermore, long-term growth is propelled by productivity gains, not by consumer spending. From this standpoint, the outlook for stocks is even more promising. Companies have rigorously cut costs and positioned themselves for a rapid rise in earnings once top-line growth resumes. Annualized productivity growth in the second and third quarters of 2009 averaged 8.2%, the highest six-month average in 40 years and unprecedented for an economy just emerging from a severe recession. Indeed, third-quarter profits, now being reported, are running well ahead of estimates.
The past decade has certainly been painful. But history is emphatic that long periods of below-average performance are followed by periods of above-average returns. Stocks still have substantial upside potential and will remain the best asset for investors' long-term portfolios.
Siegel is the Russell E. Palmer Professor of Finance at the University of Pennsylvania and is the author of Stocks for the Long Run