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COMMENTARY: WHY STOCKS AREN'T A WILD BET

Call it the baby-boomer retirement mantra: Stocks are for the long haul. Many boomers believe that over time, equities offer better returns--with less risk--than bonds. The talk on Wall Street is that this conviction, combined with demographics, helps explain the stock market's remarkable performance and why it may still have a way to run.

One sign of this conviction may be the sharp narrowing in the so-called equity risk premium. Investors typically demand a higher return over time to compensate for the risk of owning stock, which represents a bet on entrepreneurship, vs. bonds, which are contracts that spell out when borrowers must make principal and interest payments. One way to measure the equity risk premium is to look at the difference between returns on stocks and bonds. Since 1946, stocks have returned about 6 percentage points more than debt, in real terms. Since the bull market began in 1982, stocks have had an average real return of some 13%, vs. almost 10% for bonds.

BRAWNY BONDS. But the narrowing equity premium largely reflects a strong bond market. Bonds do well when inflation is low and investors are confident they will get their money back. The equity premium has been slim during earlier periods of stable prices. For instance, it was a mere 1.9% a year from 1816 to 1870, and 2.8% annually from 1871 to 1925.

Perhaps even more important, the stock market is at nosebleed levels because investors believe there is more good news to come, not because they believe equities are no riskier than bonds over the long haul. Investors are thus making a risky bet on stocks. But it's far from a crazy one, even with a 26 price-earnings ratio on the Standard & Poor's 500-stock index.

The market's gains have been largely fueled by an enormous surge in corporate profits, quiescent inflation, and the spread of capitalism worldwide. The high p-e ratio also reflects the changing makeup of the S&P 500. For example, in 1964, a year well into an expansion and boasting a high market p-e, the average five-year growth rate of the top 20 companies in the S&P was 8%. Auto, oil, and other industrial heavyweights held sway. The comparable growth figure today is 16%, and the list is dominated by companies that use knowledge and technology, rather than oil and steel. Says Jeremy Siegal, professor of finance at the Wharton School: ''Perhaps investors are right to put high p-e's on these companies, which are at the leading edge of the global economy.''

Even with the market dominated by thriving new industries, stocks remain riskier than bonds. Recessions are part of a capitalist economy. When one arrives, bondholders will still have first dibs on cash flows, and equity holders will bear the brunt of losses. Warns Ivan Stux, a quantitative analyst at Morgan Stanley Dean Witter: ''The next time the economy hits a cyclical downturn, the naked truth of equity risk will be facing us.''

Still, with the economy strong and recession a distant concern, investors are making a reasonable bet on stocks. It has little to do with the notion that equities are riskless.

By Christopher Farrell
EDITED BY AMY DUNKIN



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