Every once in a while, I’ll teach workshops on market downturns, not because I’m predicting a market downturn but because they do happen, and I want my clients to be prepared for them. Markets go up about every two out of three years, and one out of three years they go down.

What market?

Now, when I say “market,” what market do I mean? There are markets all around the world. People talk about how “The market did this, or the market did that,” but they don’t say which market they’re talking about so it’s almost meaningless. In the year 2000, for example, value stocks went up when large S&P 500-type companies went down. Then in 2001, big US companies went down again, by 12%, and small value companies went up 34%.

There will be weird years like last year, where the S&P 500 went down a little bit, but a lot of other areas went down more. There will be years like 2017, where international markets trounced US markets. There will be years like 2016, where US markets trounced international markets. And that’s what diversification is all about.

So when I talk about markets, I’m just talking about them in general, even if you diversify, you can have two out of three years where the market goes up and then one out of three where it goes down. So it might be one out of four. It just really depends on how well diversified you are. When I talk about markets, just realize that when most people say the word “market,” they’re talking about the S&P 500 or the Dow Jones. They’re not really talking about diversification because that’s not how the world tends to think.

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“The market” is an oversimplification. People often get into trouble because they oversimplify everything. If you looked at the last five years, you’d say, “Hey, wow, the S&P 500, it’s done really well compared to every other asset category.” But it just depends on what time period you’re looking at. If you go back 20 years, it was the worst asset category. The S&P 500 was not even close to the others. Small companies did better—small value, small international value, international, large and international large value, and emerging markets all did better.

An unbelievable academic study

An academic study came in that I could not believe: “This explosive discovery about stock and bond returns will shake your views on investing.” First of all, this kind of stuff tends to come out when the markets are a little bit shakier, when people are saying, “Are we going into a recession? This Trump with the tariffs and blah, blah, blah.” People are all trying to predict the future; that’s it.

Think about it, after the market goes down and people turn on the TV or listen to the radio, what is it they are looking for? People are looking for a prediction about the future because that’s the way people are built. We want to try to protect ourselves. It’s only natural. But the problem is that those people on TV, radio, and any place else that you would go to have no more of a clue than anybody else.

They have no idea what’s going to happen next. And if they did, they probably wouldn’t tell you. So the problem with our desire to constantly watch what the market is doing is that the market is driven by a desire to predict the future, and as of yet, nobody’s been able to predict the future. Nobody has shown that ability yet, so why would we expect somebody to be able to do it now? And again, why would they tell you?

If you really knew what was going to happen in the future, you would make a whole lot more money if you just kept the information to yourself. Then you could act on it and make more money. If what you knew got out there, oh my goodness, everybody else would act on it. If the prediction is that the market is going to go up, people are going to drive the prices up. If the prediction is that the market is going down, people are going to sell and drive prices down—they’re going to ruin it for you!

People throw their predictions out there because it will drive behavior. Some people pay close enough attention to what the “experts” are saying so that when they make a prediction, the market can actually go up or down a little bit. As a matter of fact, there was a university study conducted of one popular “market guru” with a large following. The study found that you’d do better selling what he told people to buy.

The study pointed out that when the guru said, “You ought to buy this,” the price indeed did go up, but it didn’t go up enough to cover the costs of purchases. That was the big deal. So fund companies recommend particular stocks to the public because they hope it’ll create some demand and drive up the price, which benefits them. And then the company will go sell. It’s called pump and dump. That’s what they actually call it.

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So this guy says, “An explosive discovery about stock and bond returns will shake your views on investing—How would you change your financial planning strategy if you couldn’t count on stocks to outperform bonds? Not just for a year or two, but over your lifetime. Alarming as the possibility may be, new research suggests that you need to take it seriously.” So this guy—a professor out in California— painstakingly reconstructed stock and bond market returns to the 1700s. He concluded that, “Except for 40 years of the past 220 years, 1942 through 1982, stocks and bonds have produced essentially equal returns.”

Can bonds outperform stocks?

Now, there are many problems with this, number one, the data prior to 1926 isn’t that great—it’s out there, but there are holes in it. Next, if you look at stocks over just the past hundred years, the return numbers don’t line up. If you owned equal amounts of every US stock, excluding the smallest 20%, you would have enjoyed an average annual growth rate of 11.5%—8.3% after inflation. This data comes from the University of Chicago database called CRSP (the Center for Research and Security Prices); we call it the CRSP index, and it has some of the most reliable data out there, going back to the 1920s. This data gives the real number.

Now the question might be, “Well, is that just because of that 40 year period he was talking about right there?” No, because if you look at the S&P 500 and look at 1926 to 1955, a 30 year period that included The Great Depression, World War II, and the Korean War, the rate of return was 8.5%, which was significantly higher than bonds. If you look at 27 to 56, and 28 to 57, and go on, look at every 30-year period, it was significantly higher than bonds.

So they’re talking about 11, 11.5% return, with an inflation adjusted of 8.3%. Inflation adjusted is what counts when you’re talking about investing, because before inflation, we might look at a return and go, “Wow! I got a 5% return on bonds!” But wait a minute, what was inflation? It might be four percent, which means you basically got a one percent return.

Now, over the same period, fixed income investments average 4.3% with an inflation adjusted return of just 1.1% per year. There’s a pretty big difference between 8.3% and 1.1%. So the real returns from equities—and this is all from the University of Chicago—were nearly seven times higher than that of bonds.

If you started with $1000 in bonds, it would have grown to about $29,000 after 20 years using real returns. That same amount invested in stocks would have grown to a $414,000, or 14 times as much. You take this all the way back to the 1920s and it becomes ridiculous. $1,000 dollars in bonds after inflation grows to about $2,900, versus stocks at 2.3 million.

There are only two decades where you actually had an out-performance of bonds versus stocks. The first is the 1930s with The Great Depression. I was reading about this in an article, and the other example the article gave was the 2000s. And because I know the market so well, I know that it couldn’t be true if a person had diversified. In the 2000s, a person actually had a much higher return in equities if that person had diversified between large, small, large value, small value.

But, again, when a person says “the market,” they only mean large US stocks like the S&P 500, because there was no return in the S&P 500 in the 2000s. So technically we could go back and say that in only one decade did stocks not outperform bonds throughout history—and that decade was a pretty severe decade.

The Great Depression and the future

It’s kind of interesting when you look at the period of The Great Depression; there wasn’t the disclosure and regulation on markets like there is now. You hear people say, “Well I know people lost everything during The Depression.” But not if they held on, because yes, 1929–1932 was nasty, but if you were hanging on and you didn’t go and sell, ’33, ’34, ’35, and ’36 were phenomenal years. A person could have literally gained back everything they had lost in that four-year period.

But why did people lose everything? They lost everything because they went and bought on margin. They borrowed money and put it in the stock market, which seemed great when the market kept going up; but when all of a sudden the market went down, not only did they have to sell what they held, but they had to pay back the loan, and they had no money to do so. There was no regulation on that like there is now, and that’s how people lost everything.

Some of you might be saying, “Okay Paul, I’m not worried about the market in the past. I’m more concerned because I’m investing for the future.” To do that, we have to understand where our future returns come from. Now, there are no guarantees about the stocks, but you have to understand that there are no guarantees in bonds either. An unexpected calamity can make it so borrowers cannot pay you back. So don’t get to the point where you’re going, “Man, I just like the guarantees. I love the insurance company.” I’ll share some things about insurance company guarantees in a future blog.

Where do the return differences come from?

We’re just talking about bonds now, where a company or a government has borrowed money. Where does the rate of return come from? The rate of return comes from interest payments. They’re borrowing your money, and so they have to pay you interest, and that’s where all your returns come from with bonds.

What about stocks? Stocks give the buyer rights to the profits of the company. And there’s this concept that I often teach in our workshops called earnings yield. And I’m not going to get into the whole of it right now, but, essentially, I get the rights to all the future earnings of the companies I own.

These future earnings function in much the same way as bond interest payments. The difference is that there’s more risk—interest payments are fixed, but earnings can go up infinitely, or down infinitely. There’s more risk, but there’s also more potential for reward. This is what Warren Buffet meant when he said stocks are bonds in disguise. The whole purpose of a company is to earn money, and when I own a stock, I have rights to those earnings.

How does this work out practically? Historically, in order to buy a stock, I have to pay $16 for every dollar of company earnings. That’s the earnings yield. Just like I get a dollar of interest for every hundred dollars that I put in a bank, I get $1 of earnings for every $16 I pay for a stock. As we speak, large US stocks are selling for about 17–18 times earnings—a little higher than historical averages. 1 divided by 18 gives us an earnings yield of 5.5%.

If you’re well-diversified, you’re paying more like $13 for every dollar of earnings, a much lower price. And if you look at international markets, it’s 9–10. So the earnings yield would be about 10%. If earnings come through as expected, that’s the earnings yield.

Now, earnings will fluctuate all over the place, but how does this compare to bonds? Bonds are paying around 2% right now. And remember, that doesn’t mean guaranteed. So while it’s not guaranteed stocks are outperforming bonds as they historically have. There are no guarantees in life, but the reality is, stock pricing is not different than the historic norm right now.

Large US stocks have historically sold for 16 times earnings. They’re selling for almost 20 times right now based on forward earnings. That’s higher than normal but not outlandish. Every other area of the market, however, is selling for less than that. While that doesn’t mean that everything else will outperform large US stocks, it does tell you—just looking at the earnings yield—that the other areas of the market have a higher expected return. And, over the last 20 years, they have outperformed the S&P 500.

But again, this is not a prediction about the future. I don’t ever do that. And anybody that does do it and says, “You ought to be putting all your money over here right now,” or “you need this,” or “you shouldn’t be holding that” doesn’t have any idea what the market will do. Lots of “experts” were saying to get out of US stocks in 2011. Well, that was a really bad idea. A lot of these guys were bullish on the market in 2018 and look how that turned out. No one can predict the future.

In the late 1980s when I got into this business, people were saying to me, “Paul, you got your securities license, great, congratulations. Don’t put any of your clients in US stocks.” Why? Because international markets had performed US stocks for two decades. It was bad advice, but that’s what the investment industry does. They constantly look at the short-term past and they tell you what’s going to happen in the future. How many times do they need to be wrong and still call it a profession?—as long as people keep buying it.

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Written by Paul Winkler

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