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Times like these give investors new insight into the phrase "stocks are risky." The Wilshire Total Market Index has given up all the gains of the past two years, and the Nasdaq has returned a negative 22% over the same time period. More than $4 trillion in market value has evaporated.
The gloom in households and executive suites is deepening, and not even a half-point cut in the Federal Reserve Board's benchmark interest rate could revive flagging spirits -- or stock prices. It's enough to make even the boldest, most bullish investor question his faith in equities.
DARKER SIDE. So what to make of it all? Casting a cold eye on the market, it seems clear the extreme volatility and cascading values we're seeing now are the darker side of equities' superior long-term performance. Stocks represent the vagaries of management and entrepreneurship (Internet stocks, anyone?) while bonds are contracts that spell out when borrowers must make their payments.
When the economy takes a nosedive, bondholders have first dibs on corporate cash, while equity holders bear the brunt of any losses. Thus, investors expect a higher return on equities to compensate for the greater risk of owning stocks instead of holding bonds or cash. And history has supported that: Since 1946, stocks have returned about 6 percentage points more than bonds and bills, after taking inflation into account.
That disparity seems like it ought to be enough to keep investors in stocks, even after taking a bear-market mauling -- provided they remain focused on the long term. But many economists, while still convinced that equities should remain the core of any long-term portfolio, now add a caveat: Investors shouldn't expect real equity returns to beat real bond returns by anywhere near the post-World War II margin.
GREAT PUZZLE. Truth is, exactly why there has been an enormous difference between returns from equities and relatively riskless fixed-income securities such as Treasury bills and bonds is one of the great puzzles in finance. In a now classic paper, "The Equity Premium: A Puzzle", economists Edward C. Prescott and Rajnish Mehra argued that equities, after taking into account investor attitudes toward financial risk, should have commanded a risk premium of around 1% rather than the actual 6% for the period they studied, 1889 to 1978.
Their deceptively simple yet seminal article was written in 1979, but it bounced around a deeply skeptical profession for a half-dozen years before being published in The Journal of Monetary Economics in 1985. Since then, thousands upon thousands of articles have been written that attempted to solve the puzzle, with solutions ranging from the herd mentality on the Street to the unexpected surge in inflation during the 1970s.
In two more recent papers, Prescott, along with economist Ellen R. McGrattan, revisits the equity-premium question. The two University of Minnesota economists argue that their theoretical model suggests the real return on stocks and bonds should hover around 4% in the future, a prediction consistent with the current real rate on U.S. Treasury inflation-protected bonds. Although other factors, such as liquidity, affect how investors value securities, they add that investors shouldn't expect an equity "risk" premium of more than a negligible 0.1% to 0.2%.
REGULATORY BARRIERS. "The equity risk premium is no more," declares Prescott. Indeed, Prescott and McGrattan say risk has nothing to do with the gap in stock and bond returns over the past half-century. Theirs is a story of tax, regulatory, and institutional change, not volatility, standard deviations, and risk aversion.
In the 1950s and 1960s, legal and regulatory barriers prevented many pension plans from investing in stocks. Even more important, equity investors shouldered a huge tax burden, with a top marginal rate of 91% from 1947 to 1962. So it took high pretax returns to lure investors into the stock market, they argue.
Contrast this scenario with today's investing environment: Equities are now the foundation of institutional and individual pension plans. Tax burdens have been greatly reduced, thanks largely to lower income-tax rates and the ubiquity of tax-deferred retirement-savings plans. For instance, the effective marginal tax rate on dividends fell from 53% in 1950 to a little over 15% in 1996, calculate the scholars.
RUNNING CLOSER. Of course, their recently published perspective is generating controversy among their peers. But other factors also suggest a narrowing equity premium. Corporate earnings are less volatile than before as swings in the business cycle have moderated over time. Market history shows that stock and bond returns run close together when inflation is stable.
So, next time you're plugging some return numbers into a retirement-planning calculator, it's a good idea to use far more conservative numbers than the broad brush of the postwar period would suggest. Odds are stocks will still outperform bonds, but by a much smaller margin than the past half-century would suggest.
By Christopher Farrell Edited by Patricia O'Connell
Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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