Thursday, May 19, 2011

Evidence of How Difficult It Is to Garner Excess Returns in the Stock Market

In January 1995, the Republicans took over Congress for the first time in, almost, forever. Quickly a form of gridlock took place that helped the stock market levitate. The R's wouldn't let President Clinton spend, and he wouldn't let them cut taxes. So the cash budget balanced soon enough, capital gains taxes were cut, and the prior record of three consecutive years of 20%+ stock market gains gave way to five years- 1995-99 inclusive. And then the S&P 500 hit a new record late in 2000. It was an amazing run. Since January 1995, the U. S. economy has only been in recession for about 8 quarters out of the 65 completed quarters since then. This is a historically better than average performance. So one would think that stocks have been fine performers overall.

Here are the stats. The S&P 500 has risen from 470 to 1340 (approximate numbers). This is a compound annual return of 6.60%. Adding in dividends brings the annual return to about 9%.
If one invested in a low cost index fund to mirror the index, fund expenses would bring the total return lower. And of course, assuming the fund is not held in a tax-exempt vehicle, taxes on dividends and capital gains would have been taken.

Also at the beginning of 1995, 10-year Treasuries yielded 7.2%, and 30-year T-bonds yielded 7.7%. Given a typical discount, that suggests that high-grade muni bonds would have yielded about 7% for long-term bonds. So, munis would have been as good as stocks for taxable accounts from then till now.

For retirement accounts, where tax rules for the unrealized appreciation inherent in zero coupon bonds are not relevant, the total return from a zero coupon 30-year Treasury bond (non-callable) can be calculated as follows.

At an annual yield of 7.7%, the price for a $1000 face value bond would have been $108. In other words, $108 in 1995 would be promised to turn into $1000 in 2025, with no interest payments for all that time. Today, 16.4 years later, this bond would now be a 13.6 year zero coupon bond, which I am estimating would be trading around $620 to give a yield to maturity of something over 3.4%. Thus the bond would have risen from $108 to $620 in 16.4 years, which my interest rate calculator says is about an 11.2% per year annualized return. This return is from the starting interest rate of 7.7% enhanced by a decline in market interest rates, further enhanced by the upward slope of the yield curve.

In other words, a time period that began with the greatest 5-year surge in stock prices in the history of the United States (at least since the dawn of the 20th Century) has led to equal stock market performance to that of plain vanilla municipal bonds for taxable accounts and to significant underperformance to that of a plain vanilla zero coupon Treasury bond for tax-deferred accounts.

In my view, this example should "put paid" to the idea that most people should put most of their investment funds in the stock market all of the time.

Copyright (C) Long Lake LLC 2011

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