Stocks, the Asset Class of Choice For Long Term

In keeping with the macro-theme of setting the table for conversation related to equity investing, this article by Dr. Jeremy Siegel (www.jeremysiegel.com/) discusses why stocks remain the asset class of choice for long term return. He also shares some basic fudamentals of equity-analysis.

The following are just some small excerpts from the piece that is worth chronicling:

During the past 204 years (through 2005) stock investors have earned an average 6.8% per year after inflation and that return has been remarkably stable over long periods. Over the past 80 years, real stock returns averaged 6.7 percent per year, and since the end of the Second World War, the annual return has been 6.8 percent. This return includes both capital gains and dividend income and is measured after the effects of inflation have been subtracted. These numbers mean that on average, investors' wealth has doubled in purchasing power every decade in stocks, a feat rivaled by no other asset class.

Stock returns are composed of the sum of the average real return on safe bonds, such as U.S. government bonds, which has been about 3 percent, plus an extra risk premium that has averaged between 3 percent and 4 percent per year. This risk premium has propelled stocks above other asset classes in investor returns.

Earnings Yield

The earnings yield on stocks is analogous to the current yield on a bond, which is the annual coupon received by bondholders divided by the price. If a bond is selling for $1000 and pays $50 dollars a year in interest, we say that the current yield on the bond is 5 percent. If a stock is selling for $100 and earns $5 per share, its earnings yield is likewise 5 percent.

But there is a critical difference between the earnings yield on stocks and the current yield bonds. Bonds, except for a small part of the treasury market called "inflation protected bonds," are promises only to pay dollars. No matter what the growth in the economy or what the rate of inflation, the payment of the principal or the interest will never increase, and could fall if the paying entity has financial problems.

Stock returns are much different. Stocks are claims to real assets -- land, capital, property, ideas, trademarks and patents, among other assets that produce real goods and services. Over long periods of time the evidence is overwhelming that the price of stocks will keep up with rising prices of the goods and services firms produce. As a result, the return on stocks is best described as a "real" return, and not just a nominal or money, such as bonds offer investors.

The long run data are consistent with the view that the earnings yield predicts real stock returns. Since 1871, the first year that definite data on aggregate stocks earnings is available, the average price-to-earnings on stocks is 14.4. That means that investors have paid on average $14.40 for every dollar of current earnings.

The historical earnings yield on stocks, which is one over the P-E ratio, has therefore been 6.9 percent. That is virtually identical to the average real return on stocks over this period.

Earnings Yield and Future Stock Returns

As of early March, the projected 2006 earnings on the firms in the S&P 500 Index is $84.81. With the index level recently at 1286, this leads to a P-E ratio of 15.16 and an earnings yield of 6.59 percent. Some view operating earnings as a too-optimistic way of looking at the profits since analysts are often overly optimistic about firms' prospects.

To avoid this, we can take the ultra-conservative "core earnings" concept that was developed in 2002 by Standard & Poor's Corp. that strips away accounting conventions used by firms to inflate their earnings. Standard & Poor's projects core earnings for 2006 at $77.32, which leads to an earnings yield of about 6 percent, the best conservative forecast of future real returns on stocks.

A 6 percent real, after-inflation return may not seem great compared to the 13 percent real returns enjoyed by investors during the booming 1980s and 1990s, but it certainly looks good compared to what is now offered by bonds. Long-term U.S. government bonds now offer a yield just above 4.5 percent, but this is before inflation is subtracted. With a 2.5 percent forecast rate of inflation, this leaves a real, after-inflation return of only 2 percent. This looks right since the US Government's inflation protected long-term bonds also offer yields of about 2 percent.

The difference between the 6 percent forward looking real returns on stocks and the 2 percent on bonds is gigantic, especially when measured over the long run. A $100,000 placed in a 30-year inflation protected U.S. government security will yield about $181,000 after inflation in 30 years. In contrast, a diversified stock portfolio at 6 percent real return will yield $574,000 of purchasing power, more than 3 times as much as in bonds.

The bottom line is that stocks still offer far better returns than fixed income investments. And given what I had written previously in this column about real estate, I think that stocks will also outpace the returns on real estate over the next decade. Stocks are the place to be for long-term investors. Future columns will show how investors should structure their portfolio to take advantage of these gains.

Dr. Siegel is currently the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, has written and lectured extensively about the economy and financial markets. He frequently appears on CNN, CNBC, NPR, and others networks and is a regular columnist for Kiplinger's with contributions to The Wall Street Journal, Barron's, Financial Times, and other national and international news media to his credit. He is the author of numerous professional articles and two books: "Stocks for the Long Run" and, most recently, "The Future for Investors."