Stocks for the Long Run? (Part II)

In “Stocks for the Long Run?” I say that

unless the course of the regulatory-welfare state is reversed, a prolonged downward shift in the real rate of GDP growth is in the works — probably to about 2 percent. At that rate, expect a continuation of the present trend [since 2000] — stock-price “growth” [adjusted for inflation] of about -4 percent a year.

Be sure to note the minus sign in front of the 4.

Stocks are not bound to rise predictably over time, despite graphs like the next one, which I constructed from the data set cited in “Stocks for the Long Run?”. “Price” (the blue line) traces the real growth in the value of S&P Composite Index; “price + dividends” (the orange line) traces real growth in the value of the S&P Composite Index plus dividends paid on the stocks comprised in the index; “dividends reinvested” (the green line) traces the real value of the S&P Composite Index if dividends had been reinvested in shares of the stocks comprised in the index (green line):

From 1871 through 2010, the average annual increase in the value of the S&P Composite, with dividends reinvested, was 6.7 percent. This kind of hypothetical long-term “return” is cited often as a reason for buying and holding stocks. But a real return of 6.7 percent is not graven in stone, as the following chart indicates.

After a period of decline in the early 1900s, the cumulative rate of return on the S&P Composite, with dividends reinvested, dropped to 5.3 percent in 1920, jumped to 8.3 percent in 1929, plummeted to 5.4 percent in 1932, returned to 7.6 percent in 1966, dipped to 6.2 percent in 1982, climbed back to 7.4 percent in 2000, and (as noted above) dropped to 6.7 percent by the end of 2010. In other words, long-run averages can be moved considerably by short run bouts of what I call “irrational exuberance and rational pessimism.”

Moreover, as a practical matter, the buy-hold-reinvest strategy would not work if there were a massive influx of stock-buyers intent on buying, holding, and reinvesting dividends. They would be chasing illusory returns because massive purchases of stocks would not be rewarded (quickly, at least) by proportionate increases in corporate earnings, which is the main driver of stock prices in the long run. The more likely result would be a bubble — like those of the late 1920s and late 1990s — which would burst, leading to lower stock prices and a greater reluctance to invest in stocks.

More realistic measures of expected returns from buying and holding stocks are depicted by the “price” and “price + dividends” lines. At the end of 2010, the average annual real return on the S&P Composite Index since 1871 was 2 percent. With dividends, the average annual real return was 2.3 percent. But almost no one — not even an institutional investor — is likely to hold stocks in the S&P Composite Index for 140 years.

It makes sense, therefore, to consider shorter holding periods: 10, 20, and 30 years.

If history is any guide, consistently positive real returns on stocks are available only to the relatively rare investor who adheres doggedly to the buy-hold-reinvest strategy for 20 years or longer.

But history is not a reliable guide because — unless the course of the regulatory-welfare state is reversed — the rate of GDP growth will continue to fall, and stock prices are likely to fall in sympathy.

Politics and Prosperity

“Government is a disease masquerading as its own cure.”

Stocks for the Long Run? (Part II)

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