The Dow Jones Industrial Average has a mean return of around 7.5% over the past 100 years. This fact is no surprise to the majority of stock investors, experienced veterans or otherwise. We have all been conditioned to believe the Sacred Rule of Investing which states that stocks outperform bonds over the long term. Stocks have undoubtedly outperformed bonds over the past 100 years, but what will the next 100 years hold in store for the financial markets?
Conventional wisdom says that stocks will outperform bonds over the long term since stocks are inherently more risky than bonds. Bondholders are the equivalent of creditors while common stock holders are treated as part owners. If a company is in financial trouble and is forced to liquidate through bankruptcy, bondholders get paid in full before stockholders will see a dime.
This fact obviously is a strong indicator if not complete proof that stocks are more risky than bonds. In theory, those that take greater risks will be rewarded with greater returns in the long run, indicating that stocks should outperform bonds.
Consider this situation though: in some imaginary country, the above facts are well known by the general populace. A large portion of this country’s net invested dollars are in long-term retirement accounts that will not be drawn upon for many years. Knowing the Holy Rule that “stock outperform bonds”, nearly everyone puts 100% of their retirement funds into stocks. In this situation will stocks outperform bonds? It is important to answer this question because the imaginary country is in fact real - It is the United States of America in the year 2006.
The Danger of Rising P/E Ratios
The past 100 years have shown an incredible demand for equities while bonds have been somewhat forsaken. The allure of hitting the Nasdaq lottery and doubling your money in a month has led many to favor stocks, as has the traditional out performance of stocks over bonds.
This has lead to price / earnings ratios increasing over the past 100 years. In fact, much of the difference in returns of stocks versus bonds can be attributed to rising P/E ratios.
There are two potential hazards to be wary of with this situation. First, P/E ratios cannot continue rising indefinitely. At some point investors will look to investments that are more fundamentally sound, even if it means going outside the stock market. A second and related pitfall is that as P/E ratios rise, return on investment must fall. In the extreme long term, the return on stocks is bounded by the rate of increase of GDP.
Never Follow The Crowd
When the whole world “knows” that the market will behave in a certain way, the dubious fact is often self-negating. There is a real danger that stocks will not outperform bonds as they have in the past 100 years. A wise investor will allocate a sizable chunk of their long-term portfolio to bonds and other non-stock investments.
In the year 2106, there may very well be an author that titles his article “Bond Returns May Not Always Be Superior…”