The stock market has had a big run on hopes that the war with Iran is ending. The S&P 500 is up more than 3% over the last month. That erased a roughly 2% loss it had for the year at that point.
Accordingly, Jason Zweig reminded readers in hisWall Street Journal column last weekend about behavioral finance research showing that investors expect bigger returns with lower risk when that’s what they’ve experienced recently.
Many investors don’t remember the last serious bear market in 2008-2009, and many more don’t remember the much longer drawdown in the 2000-2002 period.
But the more serious issue is not a bear market, when stocks drop a lot quickly. Instead, it may be a “lost decade,” during which stocks barely, or fail to, keep up with inflation for an extended period, and bonds don’t help.
In the last 125 years, there have been six periods lasting at least seven years when a portfolio of 60% US stocks and 40% US bonds delivered a negligible or negative real return. Barely keeping up with inflation, or failing to altogether, is a portfolio fail.
Late last year, Boston asset management firm GMO published a paper detailing all the historical fails of a domestic 60% stocks and 40% bonds portfolio.
Those fails have occurred six times since 1900, as GMO’s graphic below shows.
All of them occurred when stocks were above average on certain price metrics, and in some cases well above average. All of these fails were at least seven years long. One was 19 years long. Four of them resulted in real (inflation-adjusted) annualized returns that exceeded inflation by less than 1 percentage point, and two failed altogether to match inflation.
Currently, U.S. stocks are well above average on main price metrics. The Shiller PE (current price of the S&P 500 relative to the past decade’s worth of real earnings) is higher than 36. That doesn’t mean anyone knows if a crash is around the corner. But it means the probability is higher than usual for a longer-term period of lackluster returns for U.S. stocks.
Because U.S. stock prices seem high, the GMO paper recommends non-U.S. stocks, including those from Japan, deep value stocks, and various alternative strategies.
But the larger point isn’t an examination of what the cheapest securities might be currently. It’s to inform investors about U.S. market history, and that portfolios of U.S. stocks and bonds have gone through alarmingly long fallow periods in the past.
One of the ways in which advisers can help clients is to teach them market history. That can help set an investor’s expectations.
Nobody knows what the next decade or so will look like. But it shouldn’t surprise anyone if it isn’t a particularly good one for U.S. stocks and bonds — except for maybe TIPS. That means exploring other areas that may help returns is warranted. It may also mean working longer, saving more, and spending less are strategies to examine. They may not be palatable, but markets don’t always give us what we want.
