Looming Depression!, page-19

A pervasive idea that has misled American households attempting to preserve and enhance wealth is the notion that stocks always yield better returns than bonds or other assets. The proviso--"on average over the long run"--that is usually added to exhortations to own stocks should serve as a warning. So too should the sometimes added "risk adjusted" qualifier used when comparing returns on alternative stores of value such as government or corporate bonds. Consideration of some basic principles of asset price determination and the consequences of their exclusion from advice typically given to American households by brokerage firms, banks, and investment advisers can help to identify the best course for investors to follow going forward.

Institutional Bias toward Stocks

Questions about the desirability of investing in stocks as opposed to other ways to store and enhance wealth are common now during the third consecutive year in which most stock price indices have been falling. This is only natural, but it is important to remember when thinking about how to build wealth that, ex ante--looking ahead--questions about asset allocation should always be foremost in investors' minds and should be largely independent of results achieved in the past, especially over the most recent few years. Households should also remember that the intermediary between them and their pension funds and the companies raising capital to finance investments used to produce goods and services is heavily focused on selling stocks as opposed to other financial assets. The infrastructure for selling and trading corporate bonds or government bonds (just to mention two examples) is not nearly as well developed as is the equity infrastructure. Beyond that, most mutual funds are "long only" stock funds, meaning that they cannot sell stocks short, can own only stocks and treasury bills, and advertise that a certain high proportion (about 80 percent) of their funds will be invested in stocks at all times.

These rules are promulgated by government agencies that oversee mutual funds with the stated--if not realized--goal of protecting investors. In effect, most mutual funds have a sign on the door saying essentially, "we buy stocks." Some may identify categories of stocks like "growth" or "value." These are largely useless yet always positive-sounding designations designed to appeal to different preconceptions of households about wealth preservation and enhancement. Perhaps "growth stock" is meant to hint at a higher-risk, higher-return category while "value stocks" hint at steady and safer. Over time the stocks in these categories change and their performance conforms poorly to the arbitrary characterizations applied to them.

The investment industry is a group of brokerage houses, banks, mutual funds, pension funds, and insurance companies that link household savers and investors with the corporations and governments that utilize household savings to acquire assets or pay obligations. The investment industry has adapted itself to an equity culture. For most of the industry, selling stocks to the public is more profitable than selling other financial assets.

Corporate and government bonds are bought and sold largely in a wholesale market dominated by professional bond dealers, banks, and large institutions such as pension funds. Corporations and governments sell bonds to pension funds and insurance companies with intermediation help from investment banks and bond dealers who earn a commission for their services. In principle, the same arrangement could sell bonds to households although the homogeneity of most bonds and the economies of scale in their sale probably make bonds a less attractive asset to offer most retail investors. That leaves stocks to sell to households.

The positive linkage between the profitability of intermediaries and the sale of stocks means that sales efforts are directed toward inducing households to buy stocks as opposed to other assets. Given the platform provided by the August 13 Presidential Economic Forum, Charles Schwab, the head of one of the largest brokerage firms, repeated the mantra that stocks are "still the best place to invest in the long term." Sadly, while Mr. Schwab was at that forum, his company announced that it was eliminating nearly 400 more jobs.

Stocks Bias Cuts Returns

The problem with the incessant push for the public to buy equities is that it ultimately leads to lower returns. If everyone obeys the exhortation to buy stocks, share prices will be driven up so high that expected returns on equities will collapse at the first sign of doubt about earnings prospects. The further stock prices rise, the further they subsequently fall given anything but improving news on earnings, as they have done since March 2000. As this Outlook goes to press, the NASDAQ Index is now at approximately 1400, down from 5,100 in March 2000, having fallen by 73 percent in just thirty months. The broader S&P Index has fallen 32 percent, at an average rate of 14.6 percent a year, since early March 2000.

Returns over the same period on heretofore widely neglected assets, such as ten-year U.S. government bonds, have been high. Including interest and capital gains, ten-year U.S. government bonds earned a 28.7 percent total return, at a rate of 10.9 percent annually, since March 2000. This outperformance of neglected assets is exactly what one would have expected. Of course, it is no guide to what to expect in the future. But during periods when stocks outperform, the news is widely trumpeted by brokerage firms and other intermediaries. Households respond by rushing into stocks, thereby preordaining, at some uncertain time in the future, a sharp drop in equity prices. "Correction" is the polite term applied to sharply falling equity prices by account executives at most brokerage firms.

The retail mutual fund industry has learned to protect itself, to some extent, from blame for large equity losses on behalf of its investors. "Benchmarking" or relative performance indices are offered to disconsolate losers who invest in stocks. "Our fund is down 20 percent this year, but the industry is down 25 percent" is the usual consolation offered. Of course when stocks are down double digits for three years in a row, such consolation wears a little thin, so resort may be had to the observation that there are "great values" available in the stock market. Needless to say, the values are far greater than they were when brokers convinced investors to buy the stock at twice its diminished price.

Investors mainly look for the highest rate of return on assets they purchase. Many unsophisticated investors forget to adjust for ex ante risk on alternative investments in the face of a steady barrage of "stocks are best in the long run" claims emanating from virtually every brokerage firm and financial planner they ask. Reference to "the long run" is meant as absolution for stocks from higher risk. After stock prices fall, the line becomes "they will eventually go back up." They usually do, but the stocks that eventually go back up may or may not be the ones an investor owns. Some companies may not be around to have their stocks go back up, as investors in many dot-com start-ups before March 2000 know only too well. Beyond that, stock prices may fall at inconvenient times such as the years close to or in one's retirement, or just before college tuition bills come due.

Experts' Advice on Stock Buying

The brokerage industry has been joined by academic and journalistic experts who reinforce the stock buying mantra. Some, like Jeremy Siegel of the Wharton School, have argued simply that over long enough periods stocks consistently yield a higher rate of return than other investment vehicles. It will be interesting to see how the "long run" absorbs the past two and a half years, since this period has witnessed substantial negative returns on stocks while returns on bonds have been far above their long-term average. This development has led Siegel to argue that, going forward, returns on stocks will be higher than returns on bonds. During some future period this undoubtedly will be true, but the fact that bonds have outperformed stocks over the past several years is no guarantee that stocks will outperform bonds over the next few years.

The most important thing to realize is that the search by investors for the highest risk-adjusted return means that returns on all assets will be equalized over time. If stocks produce a higher risk-adjusted yield than bonds, more investors will buy stocks, thereby driving up the price of stocks and lowering the return on them, while selling bonds, thereby driving down the price and increasing the return. This arbitrage holds for any type of asset, including real estate, wine, rare books, stamps, or antique cars. Of course, some "investments," such as antique cars, for instance, yield psychic consumption benefits for their owners--they can be ogled and driven--and so their expected financial returns may be lower.

My AEI colleagues James K. Glassman and Kevin A. Hassett recommended stocks over bonds in their 1999 book Dow 36,000 because, as they asserted, if stocks were no riskier than bonds, the earnings multiple on stocks should be high enough to boost the Dow Jones average to 36,000. Indeed, ex ante, a lower risk premium on stocks would imply a higher price and, by the way, would also eventually imply lower returns ex ante for new investors in stocks. Glassman and Hassett exhorted new investors to keep buying stocks until their efforts drove the Dow to 36,000--wonderful for those who are already holders of stocks, were it to happen, but not so good either ex ante or ex post for the new investors whose buying drove up stock prices, thereby lowering expected returns for those who followed.

The Dow 36,000 exhortation was followed by a plunge of the Dow from over 11,000 in March 2000 to about 8,700 in mid-August 2002--a drop of about 11 percent annually. As we have seen, the NASDAQ, whose stock prices presumably are driven by the same underlying principles as the Dow, fell more spectacularly. Again, these disastrous results coincided with above average returns on bonds, the reverse of the Glassman-Hassett expectation. The debate remains over the relevant sample period for considering relative returns on stocks and bonds. This outcome "proves" nothing about the relative performance of stocks and bonds going forward. It does suggest that investors who expect stocks to consistently outperform bonds or other assets will experience lengthy periods of extreme disappointment, not to mention distress, should the need for cash arise.

Reasons for Depressed Stock Prices

Investors may ask: What happened after March 2000 to so sharply depress the returns on equities while returns on bonds soared? Why did equities fail to provide superior returns? The simplest explanation lies with the consideration of the marginal investor thinking about what to do with his next dollar of new investment. As investment in stocks surged in the late 1990s and prices, especially those in the favored information technology (IT) sector soared, companies employing the proceeds of stock sales kept adding more and more capacity in pursuit of the faster earnings growth upon which the higher stock prices were predicated. But the extra capacity meant that the supply of IT services expanded faster than demand. Prices of IT services and profits of IT companies consequently fell, and so stock prices fell.

The pressure to conceal the loss of earnings in an environment of falling stock prices led some companies to conceal earnings deterioration by resorting to accounting maneuvers or, in some cases, by outright fraud, as in the case of WorldCom. Revelations of such desperate measures further depressed expected IT earnings and increased the uncertainty about stated current earnings of all companies. Stock prices fell sharply.

Through all or most of the disastrous period for stocks since March 2000, the retail equity business has exhorted and cajoled American investors to "hold on." The basic pitch has remained the same: "Stocks are your best bet for the long run." That notion has cost American households that did hold on about $8 trillion over the past two and a half years.

The "buy and hold" pitch by the retail money management business is a necessary condition, but as it has turned out, not a sufficient condition for realization of the promise of higher returns on stocks than on other assets over many time periods. The sale of stocks is the bedrock of the revenues of investment firms that serve households. Further, because investment firms have proven their ability to induce households to pay up for new issues of stocks, corporations seeking a lower cost of funding play along with the bullish stock story.

Merrill Lynch's "bullish on America" campaign, which blends patriotism and a preference for stocks, probably represents the ultimate cynical appeal to unsophisticated households hesitant to jump into the stock market and thereby to help sustain rising equity prices that would attract even more households into the market. The cynicism has been underscored by the release of internal memos at Merrill Lynch and other brokerage firms wherein their stock touts chuckle about the junk stocks they are foisting off onto the American public while collecting hefty underwriting fees from the companies issuing the stock.

Looking at the stock-buying-is-patriotic (and profitable) appeal from brokerage firms, one can only imagine that effective leadership at such firms required someone either stupid or cynical enough to believe this story. Both before and after stock price debacles, the principals involved are eager to assure everyone that they believed (ex ante) or believe (ex post) in whatever company's stocks they were selling.

Stock Bias Persists

Those who doubt the equity bias of the brokerage world should try calling their broker and saying they are bullish on America and so would like to buy some U.S. government securities, treasury bills, bonds, or notes. In 1999, the brokerage firm's account executive would simply have laughed. Today they ask "seriously" if the 3 or 4 percent on five- or ten-year notes "really makes sense" when stocks--on average--yield more than 7 percent. By the way, there are virtually no brokerage fees on U.S. government securities transactions.

When all is said and done, American households are left amidst the heavy losses in stocks over the past several years with a few very old truths. No single asset class guarantees superior returns, and certainly none guarantees returns of 20 (or even 10) percent a year. No single asset class should be preferable over the others once one takes account of risks existing at the time of investment. As with every other bubble, the aftermath of the equity market bubble leaves investors with the basic truth that chasing extraordinary returns on any particular asset class, be it stocks, tulips, or bonds issued by Latin American countries, is a fool's game. If nothing else, keeping that lesson in mind, American investors may hope to earn back most of their losses over the past two and a half years with a diversified portfolio of investments. But it is probably going to take at least five years to recoup those losses. Markets tend to go down faster than they go up, and there is no reason to suppose that investing most of one's funds in the stock market will speed up the process of recouping losses suffered over the past few years.