This Time Is Not Different

Why Stocks Should Still Provide the Highest Returns

Many investment professionals have been reading the New York Times bestseller This Time Is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff. It is a powerful rendering of how often financial crises have occurred since the dawn of finance, and how often sovereign countries have defaulted on their debt through the centuries. Most important, the two authors, one residing at the Peterson Institute for International Economics, the other at Harvard, illustrate how one could predict such crises, and most important for us, outline what one could expect in their aftermath.

In the first part of this report, we will offer some salient points made by Rogoff and Reinhart which certainly apply to this moment in financial history. The second half will offer some historical context to likely asset class returns based on where we are today.

The first point to be made is that there are three kinds of financial crises, including the type we recently endured, which are financial bank crises. Reinhart and Rogoff report that “The aftermath of systemic bank crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources”. In fact, they point out that while too much debt leverage among consumers, and commercial and financial enterprises are typically the cause of adverse financial events, the recovery is held back primarily by fiscal drag caused by a dramatic expansion in sovereign debt that must be paid down over time. On average, government debt rises 86%(!) during the three years following a bank crisis. Real housing prices drop an average 35% over six years; equity prices drop 56% over a 3 ½ year span; the unemployment rate rises seven points during the downward phase lasting over four years; and output drops 9% lasting two years.

Does all this sound familiar? Bear in mind that this book was published in 2009. Clearly, this time is not different.

Certainly salient to our current situation, financial crises, particularly those that are long and difficult to resolve, can have profound effects. After financial crises, asset market collapses are deep and prolonged, there is a sizable decline in output and employment, and the value of public debt explodes. A general deleveraging is required, which has largely been accomplished, except for the large amount of sovereign debt still accumulating. Certainly, this sovereign debt overleverage could sow the seeds for the next financial crisis. It is the recognition of this risk which is holding back the stock market.

It is clear that our recovery from The Great Recession will be long and slow. Where are we on the path to recovery? Real housing prices peaked in late 2005. Add six and half years and that would put the bottom at mid-2012. That sounds about right. Equity prices peaked in the third quarter of 2007. Three and a half years would be early 2011. The stock market recovery actually began two years earlier than that. The unemployment rate did rise about seven points from the bottom. Four years from the low point in unemployment in 2007 would be 2011.

All of this suggests that based on history, the worst is behind us and the stock and bond markets will continue to heal.

Is Europe about to experience a financial crisis due to its overleveraged junior sovereign partners within the Eurozone? Reinhart and Rogoff point out that there are usually four conditions that trigger financial crises: massive global current account imbalances, asset price inflation, rising household leverage and slowing output. All four conditions were met just prior to the 2008 bank crisis. In Europe today, only two conditions are being met: current account imbalances and slowing output.

Sovereign defaults have been with us for centuries. It is no surprise that Greece is on the brink of default. In fact, Reinhart and Rogoff point out that since 1800, Greek debt has spent more time in default than being current with their debts. It is a classic serial defaulter. What is happening in Europe has played out on numerous occasions throughout the centuries, except the solution must be countenanced by many countries as long as Greece remains part of the Euro zone. In other words, this time is no different from myriad previous sovereign default events.

Are we about to have yet another crisis in the United States caused by the large federal deficit? The U.S. also is satisfying two of the four conditions: current account imbalances, and slowing output. Will this trigger a “run on the bank” scenario like the one playing out in Greece? Not yet and maybe not for a while. The U.S. possesses a unique advantage in that the dollar is the primary exchange currency and is still perceived as the least risky currency to possess in times of trouble. It is still true today. This factor will likely forestall a currency crisis much longer than would normally be the case for a small country’s currency. We probably have a few years to solve our sovereign debt issues, but it is not forever, and the moment of judgment is never predictable.

Alright, let us assume for the moment that one way or the other, a solution to our debt issues will occur after the 2012 elections, probably in 2013. What returns could one expect from various asset classes after a financial crisis like the one we have experienced, one which has quite lingering aftereffects?

The financial bible for U.S. asset returns is Ibbotson’s Stocks, Bonds, Bills and Inflation Classic Yearbook, which is now published by Morningstar. It provides compound annual returns for various asset classes going back to 1926. It is in that year when the predecessor to the S&P 500 was created.

First, let us level set returns by asset class. It is important that investors understand what various asset classes have done through thick and thin periods of modern financial history.

The following table shows the compound annual returns for various major asset classes, plus the compound annual inflation rate, since December 1925, and what a dollar’s investment in each asset class would have returned:

Compound Annual Return

Wow! Just an extra 220 basis points in return from small stocks large stocks over 85 years gave you that difference in returns? The answer is unequivocally yes. That is the power of compounding over long periods of time. For that substantially greater return one must accept high annual variations in those returns, but clearly it is worth it over the long run. Also look at the difference in returns between large stocks, long term government bonds and T-Bills. Over the long run, less risk means substantially less returns. Even if one assumes two hundred basis points lower returns for stocks and long term bonds over the long run because of a more mature domestic economy, as we do, absolute returns will be less but the difference in relative returns will remain about the same.

But are not bonds safer than stocks? Yes they are. The variation in their returns are less than for equities, but less risk does not mean no risk, and the risk of owning fixed income investments may be greater than you think. The following table shows the number of times out of 85 years each asset class had a positive return, the percentage of times they were positive and the number and percentage of times each asset class had the highest returns among all asset classes:

Fixed Income – Number of times positive (Past 85 years)

It is not all that surprising that either small or large stocks had the highest annual returns 64% of the time between 1925 and 2010, or that T-bills had positive returns 99% of the time. But one would have thought long term bonds would have had positive returns more often than stocks. They do but not by much, really not much at all. Given the much higher returns stocks get, that is not an argument for overweighting bonds. Also, bonds are not immune from providing negative returns, and that usually occurs after returns have been higher than usual, like now.

Okay, but stocks drop more than bonds during financial crisis. That means it would take longer for returns to recover, right? What if we looked at how often there are positive returns over rolling five year and ten year periods for each asset class and the number and percentage of times an asset class had the highest five and ten year compound annual return? There are 81 rolling five year periods and 76 rolling ten year periods to consider.

Positive Returns over 5 & 10 year periods

How often there are positive returns over rolling five year and ten year periods for each asset class and the number and percentage of times an asset class had the highest five and ten year compound annual return.

Well, doing worse in a financial crisis certainly does not harm the comparative returns of stocks versus bonds over five and 10 year periods. Over rolling five year periods, stocks had a positive return 86% of the time and had the highest five year returns 88% of the time. It is important to note that even though long term bonds provide the highest returns 11% of the time, they are still not immune to negative returns. The ten year comparative returns are similar

Well that is fine, but what are the returns for these asset classes after their worst periods? The next table shows the worst five year and 10 year periods for each asset class and their five year and 10 year returns after that. Please note that the best returns were provided by stocks, and certainly not T-Bills. In fact, adjusted for inflation T-Bills provided negative real returns in both periods.

Worst 5-10 Year periods

After the worst five year period for each asset class, stocks, as usual, provided the best returns. This time the returns over bonds were way over historical averages, both on an absolute as well as relative basis. The 10 year return after the worst 10 year periods were closer, but large stocks still won. We do not know what the 10 year returns after the worst 10 year period for small stocks are because it is a relatively recent event.

One might reasonably ask, what were the comparative returns of stocks compared with bonds after the best period for bonds, which would be similar to recent events? We think you are on the verge of becoming tabled out so we will just tell you that the best five year and 10 year return periods for long term corporates and long term governments were 1982-1986 and 1982-1991, respectively. Long term corporates returned a sterling 22.5% a year for the five year period and 16.3% a year for 10 years. For the succeeding five year and 10 year period, the returns for corporates were 10.4% and 8.1%, respectively. For governments, the best performing annual returns over five years and 10 years were similar to corporates, 21.6% and 15.6% respectively, and for the succeeding five and 10 years, they returned 9.8% and 6.7%. Those are great numbers, but stocks during the five years ended in 1996 and 10 years to 2001 did way better than that: 17.3% a year for small stocks over five years, and 15.4% for large stocks, and for the 10 years, a 15.6% annual return for small stocks and 12.9% for large stocks. In other words, stocks did better than bonds after each asset class’ worst period, as well as after the best period for bonds.

Where are we now? For the five years through 2008, small stocks had a -7.7% compound annual return. That is pretty terrible but by no means the worst period suffered by that asset class. Large stocks had a 2.2% negative return. On the other hand, long term corporate bonds had a 5.8% annual return, long term governments a fabulous 10.4% CAGR, Treasuries 3.0% and inflation 2.7%. None of these returns represent the worst periods for any of these asset classes, nor their best. Nonetheless, given the comparative returns of stocks and bonds over the five years to the end of 2008, close to the end of the last major bear market, one would expect stocks to perform comparatively better, and by a large margin.

They have. For the two years ended in 2010, the annual return for small stocks was 29.7%, large stocks 20.6%, long term corporate bonds 7.6%, long term treasuries -3.2%, and T-bills 0.1%, against inflation at 2.1% a year. Wow! Well some of those gains have been given back so far this year, but stocks have still provided great returns since the end of the bear market, and significantly better than long term bonds, let alone treasuries.

Stocks are clearly performing just as you would have expected them to perform based on modern financial history. As for fixed income investments, it is corporate America that has by far the best income statements and balance sheets. Investment grade corporate bonds are well supported by record profit margins and record highs in net cash. Compare that with the U.S. government’s income statement and balance sheet.

It is our view that investors with time horizons beyond the next six months should overweight three types of investments: long term corporate bonds, dividend paying stocks and stocks for capital gains. Long term corporate bonds provide better returns than treasuries and offer far better balance sheet support, the dividend rate of the S&P 500 is above that of 10 year governments. That is an extremely rare event and a very bullish signal. Lastly, small stocks are apt to continue providing above average returns following the worst 10 years going back to 1925.

What are the takeaways here? Financial crises test the stamina of citizens because of the adverse impacts on their quality of life, not just immediately after the debacle, but many years afterward. It does not matter who is in the White House or controls congress, economic growth will be below normal for many years, but that does not mean stocks will provide poor returns. In fact, they are likely to provide above average returns over five years and 10 years. It is true that the best returns in a bull market are in the first two years, but based on history, equity returns over the next few years are likely to be positive and above that of long term bonds.

History does not exactly repeat itself, but it rhymes. We firmly agree with Reinhart and Rogoff: the worst is over. This time is not different.