Stocks Have Stunk, Sto Why Buy?

1/2/2012


Q Stocks have performed poorly since 2000. I would have been better off with bonds. Why should I bother with stocks anymore?
A Many stock investors have asked the same question. Since the start of 2000, the S&P 500 Index has lost 14% of its value. The index rose in seven of the years and fell in four, while 2011 was up less than 2% as of Dec. 27. But despite the ugly 12-year period, we suggest you don't give up on stocks, and history supports that advice. Consider three facts:

• While the 12 years ending 2011 don't look good, in the previous fifty 12-year periods ending in December, the index did not once deliver a negative return. During those 12-year periods, returns averaged 162%. Could we see another long stretch of negative returns? Yes. Is it likely? No.

• From 1926 through 2010, large-company stocks delivered an annualized return of 9.9%, dwarfing the returns of bonds. Over time, stocks tend to outperform bonds, and investors who ignore stocks limit their long-term portfolio returns.

• At the moment, stock valuations look attractive relative to historical norms, with large-caps especially appealing. On average, S&P 500 Index stocks trade at less than 17 times trailing earnings, 19% below the average since 1990. Historically, investors who purchase stocks when they are cheap tend to do well.

Q OK, so stocks earn better long-term returns. But they are also more volatile than bonds. Why should I take on that volatility?
A Because over the long haul, the returns of stocks justify the additional risk, as illustrated in the nearby table. From 1926 through 2010, large-company stocks delivered annualized returns of 9.9%, while small-company stocks managed 12.1% returns. In contrast, long-term corporate and government bonds posted annualized returns of less than 6%. To put that in context, $1,000 invested in large-cap stocks at the end of 1925 would have grown to nearly $3 million by the end of 2010, while the same investment in government bonds would have been worth about $93,000.

Of course, the bond returns were far less volatile, as measured by standard deviation, which considers how widely returns are dispersed around the average. To measure risk-adjusted returns, we calculated the Sharpe ratio. We subtracted the average annual return of a risk-free asset (Treasury bills) from the average annual return of each asset class, then divided the excess return by the standard deviation of annual returns. The higher the Sharpe ratio, the higher the risk-adjusted returns. By this metric, stocks beat bonds.

Most investors should hold at least some fixed-income investments for diversification purposes. But given stocks' superior return potential, they belong in the portfolios of just about every investor.

STOCKS OUTPERFORM BONDS OVER LAST 75 YEARS
From 1926 through 2010, stocks have delivered higher risk-adjusted returns than bonds as measured by Sharpe ratio, which considers returns above the risk-free (Treasury bill) rate divided by standard deviation. Stocks delivered higher highs and lower lows than bonds.
1926 Through 2010
Annual.
Return
(%)
Avg.
Return
(%)
Standard
Deviation
(%)
Sharpe
Ratio
No. Of
Positive
Years
Maximum
12-Mo.
Return
(%)
Minimum
12-Mo.
Return
(%)
Large-Company
Stocks
9.9
11.9
20.4
0.40
61
54
(43)
Small-Company
Stocks
12.1
16.7
32.6
0.40
59
143
(58)
L-T Corporate
Bonds
5.9
6.2
8.3
0.30
68
43
(8)
L-T Government
Bonds
5.5
5.9
9.5
0.23
63
40
(15)
Source: Morningstar.

Q I'm still worried about the economy because corporate profits tend to drive stock prices. Will profits continue to rise?
A History suggests they will. From the middle of 2007 through the end of 2008, corporate profits declined for six consecutive quarters. It was a scary stretch, but the only six-quarter string of profit declines in at least 65 years. We should not see a repeat any time soon.

Over the last five years, U.S. corporate profits rose at an annualized rate of 3.6%, while the S&P 500's per-share operating profits grew at a 2.2% annual clip. Corporate profits have expanded at an annualized rate of 10% over the last 10 years and 7% over the last 65 years. Only 20% of the five-year periods since 1952 saw annual growth below 3.6%.

In the year ended September, corporate profits rose nearly 8% and the S&P 500 Index managed per-share-profit growth of about 20%. While growth could slow over the next year, the next five years should see profit growth well above that of the last five.


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