Stock Market Returns ... When 8% = 11%

Dollars are the currency we use and the way we value various alternatives when making purchasing or selling decisions.

But which kind of dollars we're considering is hardly ever clarified. Nominal or real makes a huge difference. When I was young, McDonald's hamburgers cost 15 cents, and fries and a coke were a dime each. 35 cents in total. Today the costs are higher -- much higher -- or are they?

Well, let's keep our McDonald's example in mind as we take a look at investment results and the impact of inflation on the reported numbers.

For illustrative purposes, if we have 5% inflation and a 11% rate of return on our investments. that's the same as 2% inflation coupled with an 8% investment return. The inflation adjusted real rate of return is 6% in each case.

Let's keep that in mind as we review After 30 Years: Raging Bulls to Aging Bulls:

"It was 30 years ago this week that the greatest secular bull market in history began. But is it a happy anniversary?

Given the carnage of the past 12 years—the popping of the tech bubble and the worst financial crisis in modern times—some prognosticators say that even after recent gains we may still be in the early stages of a new secular bull market. Though it may not equal what we saw from 1982 through 2000, a pale imitation still would be welcome.

The best of times tend to follow the worst ones, but the most bullish soothsayers may not be looking back far enough. Even after all the damage that has been done since 2000, the preceding 18 years were strong enough to make the total return over three decades look remarkable.

"We are at the higher end of returns, so it's going to be nearly impossible to replicate the last 30 years in the next 30," predicts James Bianco, president of Bianco Research.

The S&P 500 Total Return Index has produced a compound annual gain of 11.32% since August 1982. The average return during the entire 20th century was 10.1%, according to "Triumph of the Optimists," a study of investment returns by Elroy Dimson, Paul Marsh and Mike Staunton. While it seems like a small difference, an untaxed pot of money invested in 1982 would be 28% lower today using the lesser rate. Most investors gladly would accept the long-run return right now. But another remarkable factor of the last three decades—a historic fall in bond yields—won't be repeated.

When it comes to inflation-adjusted returns, bond bull markets are a huge boon to stocks. Conversely, the opposite can create a huge drag. For example, the decades after World War II generally were a golden period for corporate America. But from 1946 to the autumn of 1981, benchmark Treasury yields went from their all-time low to their record high. And though stock indexes did well on paper, the S&P 500 rose just 0.63% annually in inflation-adjusted terms.

By contrast, the last 30 years have seen Treasury yields go from their all-time high to new all-time lows. The effect of ever-cheaper borrowing costs and falling inflation has helped push the real return in the S&P 500 index to 5% annually, racking up gains about one-and-a-half times the typical postwar pace. That said, Treasury notes were the asset that really shined. Since 1981, they have far outperformed their long-run norm.

Another caveat is how pricey stocks are compared with the 30th anniversary of the start of other secular bull markets. The cyclically adjusted price-to-earnings ratio espoused by Yale professor Robert Shiller was recently at 21.37 times versus 16.83 in July 1962 and 12.68 in August 1951.

And then there are other differences. Back in 1982, the vanguard of the baby boomer generation was a sprightly 36 years old, whereas they began qualifying for Medicare last year. And back then federal debt was around a third of gross domestic product, well under half the proportion today.

Given these looming retirement bills and bigger debts, it is belt tightening, if not a fiscal cliff, that lies in America's immediate future. That's quite a contrast with Ronald Reagan's carefree deficit spending during the 1980s.

Asking for history to repeat itself with equities may be a tall order indeed."

Discussion

Sure, things could be more difficult for investors these next 30 years than the high returns of the past three decades. There's no way to know what the future will bring, and it definitely could be tough sledding for stock returns to match their outstanding performance since 1982.

But then again, asking for stocks to do well may not be such a difficult feat. As Mark Twain once said, while history doesn't repeat itself, it does rhyme.

Thus, we shouldn't expect the next thirty years to match the financial market's overall performance of the past thirty years.  It could do even better and in any event, should at least come close enough for horseshoes. Except for bonds and fixed income investments, that is.

Bonds did extremely well as interest rates declined continuously for the past 30 years. Accordingly, the inevitable direction henceforth is upward, thus making bonds a likely bad place to put our money for the next 30 years.

But here comes the history rhymes piece of the investing story. Putting our "safe" money in blue chip stocks in lieu of bonds will enable us to earn whatever the market gives us in the next 30 years and in inflation adjusted results, perhaps even surpass the results attained in the past three decades.

How is that even possible, you ask? Simple, I respond. Here's the logic.

Summing Up

Inflation and interest rates currently are at historic lows. Assuming they rise moderately and not explosively as the economy regains its footing over time, perhaps an inflation rate of 2%-3% will become the norm during the next decade or so. If that's the case, an 8%-9% average annual stock market return would equal the nominal 11% achieved by the market for the 1982-2012 timeframe.

In my view, that's not only possible but a quite reasonable outcome to anticipate.

And if that's what happens, 8% in a 2% inflation environment will equal the 11% of the past 30 years. Making the further move, at least for the next several years, to use stocks as replacements for bonds in our blue chip, dividend increasing, earnings growing, inflation protected all stock portfolio, will add to the expected portfolio returns.

Thus, history should at least rhyme because total portfolio returns may be even greater than those of the past 30 years, which are now properly viewed as the longest running bull market of our lifetime.

So maybe we're setting ourselves up to have another three decades of outsanding portfolio performance. Why not, especially if we can keep inflation in its cage and restore the U.S. private sector to its rightful place driving our economy forward?

But even if our investments don't exactly match but just come close to the sterling performance of the past 30 years, that wouldn't be so bad either, would it?

Thanks. Bob.