Are Stocks Really That Great Over the Long Run?
Looking back at the year 2013, it is easy to simply assume that there is a certain and possibly tangible connection between the Federal Reserve's nearly 40% increase in balance sheet level and the S&P 500's almost 30% rise in value. But, as any Fed official will tell you, the balance sheet running at the New York branch is but a byproduct of policy. It tells you very little about the amount of "money" in the economy, and very much about the dosage of manipulation. Extrapolating from there requires intermediate steps through the quagmire of financial speculation, detouring hopefully to the real money printer - balance sheet expansion.
Stock investing, apart from bouts of speculation, is mostly a long-term proposition. You are taught from the earliest exposure to finance that stocks perform the best over the long haul, and thus equities should form the basic or core section of your portfolio. There is more than a little truth to that tenet, largely determined by a long historical comparison among potential asset classes. Any glance at an Ibbotson chart will seemingly confirm not only the conventional wisdom here, but also the power of compounding that captures the face of such convention.
Again, it being the beginning of a new year, it is difficult not be retrospective about more than the last calendar. Looking backward at this millennium, it is easy to see how stock returns have been volatile and lumpy. Missing out on any of the discrete segments of bubble-inspired all-time highs dooms investors to not just underperformance, but actual failure. In fact, it is not all that much better under full participation.
Since the peak of the dot-com bubble in March/April 2000, the S&P 500 has gained 21% total (assuming no dividend reinvestments). On a compound annual basis, that's about 1.4% per year; a horrible result. The CPI-U over the same period has increased just under 37%, meaning that the CPI has outperformed the index over the same period. Calculating the compound annual return on a "real" basis we get -1.3%. Assuming that any dividends were reinvested in something with a slightly positive return only gets you back to zero.
Despite record highs in stocks right now, there has been little to gain over the past thirteen years. That itself is somewhat curious in that it certainly does not comport with the basic axiom of stocks outperforming in the long run. However, there are periods of time when such is the occasion. We know, for example, that stocks during the Great Inflation were similarly disappointing.
From the start of the Great Inflation in 1965 until the high point in stocks in 1981 (before the last leg down into what would eventually be the bottom and the start of the great bull market), the S&P 500 (again, assuming no dividends) advanced a total of 61%. Spread out over nearly 17 years, that yields a compound annual return of just 3%. Since the CPI-U nearly tripled over the same period, stock returns were downright atrocious on a real basis.
That pattern, contrary to expectations here, actually continues beyond just the Great Inflation. From 1965 to 1995, the S&P 500 advanced 5.8% per year on a compound annual basis, but just 1.5% per year when factoring inflation. And on the other end, if we start our performance period in 1998 rather than 2000, there is little improvement. The compound annual return since 1998 is only 3.8% in absolute terms, and 2% adjusting for inflation.
In fact, no matter how you measure stock returns, absence from the dot-com bubble leads to these kinds of paltry results. From 1995 until the peak in 2000, the market grew by almost 24% compounded per year. With very little consumer inflation during the period, the real return was something like 23% per year.
If you take any three of those years out of the performance equations, you end up with returns that are nothing like what is assumed out of the "best performing" asset class over the long run. Further, those calculations that end in 2013 also capture the most recent run in the market, and these all-time highs. How can it be that stocks have required asset bubbles to justify their ascent to the top of the list? To put it another way, without these asset bubbles stock returns would be on par with what you would expect from a period of high inflation. In either case, the returns are hard pressed to justify the risks of ownership.
We see that most clearly if you end your return comparison in 2009, 2010 or 2011. That is contrary to historical experience prior to the Great Inflation. In the fifteen years between 1950 and 1965, for example, the S&P 500 increased just over 400%, for a compound annual return of 11.3% per year. The CPI-U grew only 33% total, meaning a real compound annual return of almost 11% per year.
Again, what is curious here is that, like the 1950's and early 1960's, there has been little to zero measurable "official" inflation in consumer prices. That is particularly true of the 1990's and 2000's. Yet, again, without full five-year participation in the dot-com bubble and the last two years, stocks have been utterly atrocious. Not only does that more than suggest that managing risk is paramount, it points to perhaps systemic deficiencies where they were never expected.
In a very serious way that turns the recent suggestion from Larry Summers, echoed by Paul Krugman (http://www.realclearmarkets.com/articles/2013/12/20/an_economy_wrecked_by_ivy_league_phds_100807.html), somewhat on its ear. Summers suggested that the economy may be operating with a negative natural interest rate, meaning that asset bubbles would be the natural economic and financial course from policy operating with that constraint. Krugman largely extrapolated further and assumed that there might be an economic component to that idea, where real growth in income and employment has been tied to the asset bubble "necessity." Without bubbles, extending this to its conclusion, there is no economic growth.
It is particularly alarming to see that idea play out to some extent in long-term stock price behavior. If I had to couch this in terms of the Summers' paradigm, it would suggest that companies are unproductive in their business efforts aside from the bubble "boosts." Without "stimulative" monetary policy, businesses have gained the tendency to retreat from healthy expansion. Therefore, policies of low and zero interest rates (and beyond) are necessary to defeat these tendencies and force businesses into expansion. Most of these expansions are wasted resources (bubble behavior), but in the Krugman formulation wasting assets is far better than idle assets.
Where and how this negative proclivity toward productive business arrived is as yet unexamined. However, there is no shortage of comparable anecdotes.
For starters, in the late 1960's and early 1970's there was the fad or investment theme of what was colloquially known as the nifty fifty. These were a group of stocks that would be considered high growth names today. There was no single list of fifty names, only a generalized category, but it was widely known and appreciated.
What was particularly noteworthy of these stocks in the context here is that they were trading very much like what we might consider bubble behavior. You would recognize most of the names that would be widely accepted as a nifty fifty, whether they were on any official list or not. There were companies like Polaroid, McDonald's and Disney, all three with stock prices trading at better than 80 times earnings in 1972. Johnson and Johnson, Kmart (Kresge then) and Avon all traded at greater than 50 multiples. Pharma names like Schering, Merck and Eli Lilly featured PE's greater than 45.
There were only a few "tech" names on the list, as most of what we consider to be tech today was still in the office products industry as it transitioned toward computing. However, those that were alive then were certainly enjoying this favored status. IBM was at 37 times earnings in 1972, and Burroughs was just less than a multiple of 50.
While IBM is a household name today, Burroughs was perhaps one of the great pioneers of the computer evolution age. In 1960, Burroughs introduced the B5000 which was decades ahead of anything available at the time. It was revolutionary, and expansively so in the context of computing coming out of the vacuum tubes and basic transistors of the 1950's. It is considered the first third generation machine, and largely the first (depending on your definition) to feature virtual memory and multiprocessing. Further, it was the first machine to take the idea of incorporating software into its design, affording streamlined and fast usage of high-level languages.
The industry at the time was known as "IBM and the seven dwarfs", with companies like Burroughs, NCR and Honeywell competing for about a third of the market. That drove the desire for innovation and new products, particularly as the world changed over from mechanical adding machines and early computing systems into much more powerful and potentially revolutionary designs. There was massive productivity to be gained in the process (think bank tellers switching from hand counted and written ledgers to even primitive databases), and a lot of money to be made by those that could lead it.
It also meant that any business lines that were not performing had to be shed or reformulated so that resources were efficiently dedicated to staying in the competitive race. The dynamic nature of these new businesses meant incorporating all available data and business successes or failures into the operational environment. As firms succeeded, often with the application of this new technology, they displaced their competitors, forcing them to either abandon the business or get better. That process unlocked enormous business and economic potential.
In that potential were the seeds of those nifty fifty valuations. The combined efforts of IBM and its seven dwarfs were opening up vast new markets in places that nobody could envision in 1972. Investors paying 50 times earnings for Burroughs were doing so with a lot of faith in continued innovation and growth (it didn't work out so well for Burroughs, getting beat by IBM over and over caused it to merge with another of the dwarves in 1986 to become Unisys). IBM eventually commoditized the PC market with the first low-cost microcomputer in 1981, before getting shoved aside as its BIOS was "cloned" first by Columbia Data Products almost immediately after IBM's first launch.
McDonalds went from a regional rarity to almost ubiquitous. Walmart emerged and changed retailing, bringing with it productivity for consumer products. Those pharmaceutical companies began to experiment with biotechnology and moving beyond basic drugs as they acquired sufficient scale to defray big risks. It was the transition from smaller business with limited reach to the megafirms and dominant truly national businesses.
The advance of computer technology itself was a key factor in removing constraints against the size of business. Think about retailers like Walmart or Kmart having to manage inventory and individual store level factors without a centralized database. The introduction of the B5000 and the machines that followed created the space in operational management that pushed out the upper limits of size and scale. Technology unleashed the managerial revolution.
These businesses that we now look upon as mature megaliths were once the disruptive gazelles that drove economic progress. Each individual regional retailer that fell to the Walmart revolution served to increase the productive capacity of the economic system. Their resources were never idled, only re-allocated through bankruptcy or incorporation into other more successful enterprises. In every case, what may look to economists like idle resources were business signals to engage in that re-allocation process.
But if we follow this to its logical end, do we not end up where Larry Summers proposed? In other words, once all the less productive regional firms have been taken out by the "better" competition that establishes itself as the new national leader, what's left? This is the essence of the "low hanging fruit" hypothesis popular with a certain segment of economists. Now that we have gleaned as much productivity and growth from these "easy" transitions there is little left to propel economic fortunes aside from heavy monetary intrusions and their inevitable bubble episodes.
That seems to offer a compelling explanation for the longer-term dissatisfaction in share prices. The nifty fifty represented not the future of growth, but largely its apex. The innovations had already taken place and the businesses of that age were already into the exploitation phase. That share prices, as a whole and generalized, have underwhelmed since is simply due to the fact that the innovation/size transformation process was being captured by stock investors in the much more fruitful markets of the 1950's and early 1960's. There is little left for those investors that have come after, aside from financial and monetary hope-driven volatility.
I think, for the most part, I agree with this. But this is not the same as cause and effect; I see this as a symptom of a different cause rather than a cause itself. It all gets back to the idea of idle resources vs. wasted resources. Modern monetary theory holds that resources can be "un-idled" by the psychology of the modern central bank at the center of finance. In that idea is placed the value judgment that an idle resource is worse than worthless - Krugman himself has called those that fail to accept this premise as cold-hearted, as in why would anyone be against putting someone to work with resources that are just sitting around doing nothing.
But in contravening market interpretations and signals, central banks risk the potential for interrupting innovative processes that are as yet unseen or not fully developed. An idle resource to a central banker is a hole in "aggregate demand", while to the actual business it is potentially the spark to do something else; to change the nature of the business through some unknowable advancement. The profit motive is often at its sharpest staring in the face of ultimate failure.
There is no way to know how much, or if at all, this interference has been circumventing that very natural innovative process. I would surmise that the long-term difficulties seen in the stock market are a very good indication of that, potentially a crude measure of how far off-track the economy has become in the age of soft central planning. The massive monetary imbalances that have been created in the pursuit of "un-idle" resources further siphon productive potential as incentives and resource utilization pathways strain to fit this new paradigm.
The evolution of technology in the middle of the last century may have been the catalyst for that stage of growth, leading to the productivity of national scale, but I have great difficulty believing it to be the terminal stage. Simply applying Occam's Razor, it seems far more likely that the intrusion of the financial is much more fitting the circumstances, rather than the convolution of negative natural interest rates or a sudden and unexplained interruption/termination in the upward economic surge of mankind coincidentally at the exact time when central banks freed themselves from exogenous money limitations and gained full "flexibility." Financial suppression is certainly a powerful enough agent to explain all these curiosities, the costs of which we had begun to absorb but were/are obscured by the festivities of rolling asset bubbles.
