Peter Bernstein on Stocks for the Long Run

Fantastic op-ed in the Financial Times by one of my favorites, Peter Bernstein. He argues that “Stocks for the Long Run” is a misnomer, because the Long Run depends heavily on where you start.

The cold statistics have hardly been encouraging for the traditional view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts.

These data are not to be taken lightly.

If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent  a year.

He goes on to make the point that stock market returns are not independent observations from a trending data series. In fact, they depend heavily on policy decisions, regulatory framework, and a whole host of other variables that determine returns.

There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.

This, of course, leads to some scary logic. Given where we are today, how do we think about the long run return from stocks? Massive fiscal deficits, burgeoning entitlements, questions about the very core of capitalism (credit, private property, etc.) all mean that we are currently, in the first quarter of 2009, presented with a new and dangerous set of initial conditions.

Will our economy and society emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?

We can neither answer those questions nor can we claim they are a complete list of the possibilities. The unknown today seems more than usually unknown. Then my whole point remains the same. The long run is an impenetrable mystery. It always has been.

For what it’s worth, the father of Stocks for the Long Run, Jeremy Siegel, recently published an op-ed in the Wall Street Journal arguing that from a long-term perspective, stocks are exceptionally cheap. Basically, he argues that earnings from Citi, BofA, and other failing banks are weighing down the S&P core earnings, making earnings look artificially low and therefore, P/E multiples artificially high.

I tend to agree with John Mauldin, who argues that this line of logic is a bit off-the-mark. At the end of the day, these earnings matter, and though figuring out how to weight them is hard, you still need to give them some weight in the S&P index earnings.