Can History Be a Financial Crystal Ball?

Physician's Money Digest, August 2005, Volume 12, Issue 12

What kind of returns should we expectfrom the bond and stock markets inthe future? By future I mean next 10,20, or 30 years, not the next quarteror next year, because no one can tell what will happenin the short run, nor does it matter. Unfortunately,the news for the long-term returns fromcurrent levels is not good.

Bond Market Returns

Because high-quality long-term bonds are yieldingaround 4.5% now, that is what you will earn over theyears if you invest in them now. Inflation is likely toaverage 2.5% to 3% over that period, which meansyou will earn a real (inflation adjusted) return ofabout 1.5% to 2%.

Why long-term interest rates have remained solow even though the Federal Reserve has been steadilyratcheting up short-term interest rates has even Mr.Greenspan puzzled. Experts have many explanations,but in the end the explanations do not matter much.The question you have to wrestle with is, should youbuy long-term bonds at these levels or wait for betteropportunities in the future?

My recommendation is that you should do a littlebit of both. However, bonds have historically providedreal returns of only around 2%, and the future isnot likely to be much different. Also, you shouldalways keep most of your bond money in maturitiesof less than 5 years.

Bonds have provided higher returns because in theearly 1980s interest rates were in double digits due tothe fact that the expected inflation rate was also higher.Both declined over time, resulting in exceptionalbond returns. To earn similarly high bond returns, wewill have to return to the miserable economic conditionsof the early 1980s. Fortunately, that does notseem to be in the cards.

The most important alternative to fixed rate bondseveryone should consider are treasury inflation protectedsecurities (TIPS), which are currently offeringreal returns in the range of 1.5% to 2%. At thoserates they don't seem much more attractive, butremember that TIPS provide guaranteed protectionagainst inflation, which is the greatest risk you facewith long-term fixed rate bonds.

Stock Market Returns

Despite Wall Street's perennial optimism, the newson market returns is particularly uninspiring. Fromcurrent levels, stocks (as measured by the S&P 500)are likely to provide a return of only 5% to 6% peryear over the next 20 years. Why? Returns on stockscome from three sources: dividends, change in valuation,and earnings growth. Over the past 75 years,stocks provided an annual return of just over 10%.Much of it came from dividend yield, which at thebeginning of that period was more than double thecurrent yield of less than 2%.

Price-to-earnings (P/E) ratio was much lower at thebeginning of this period and increased over the years,accounting for a good part of the historical stockreturns. Currently, P/E ratio is at or above its historicalaverage, depending on how you measure it, so futurereturns will not get much help from P/E expansion.

There is no reason to believe earnings will growany faster in the future than they did in the past, soyou should be careful about putting a lot of moneyinto stocks at the current level. If you think you oryour financial advisor have the expertise and courageto wait and get into the stock market when the rightopportunity comes and everything looks bleak, thentake a wait-and-see approach with a good part ofyour market money. Otherwise, use your stock moneyfor dollar-cost averaging, but be prepared to hold andkeep investments through a market that may movesideways for many years or even go down significantlybefore going up.

What returns you earn on stocks over the yearsdepends on what price you pay for them. If you overpay—which is what you will probably do at today'sprices—you should not expect your long-term returns tomatch historical levels.

author of The Only Proven

Road to Investment Success (John Wiley; 2001)

and Financial Modeling Using Excel and VBA

(John Wiley; 2004), currently teaches finance at

the Fordham University Graduate School of

Business and consults with individuals on financial

planning and investment management. He welcomes

questions or comments at chandansen@aol.com.

Chandan Sengupta,