I was recently asked to write an article on observations gleaned over a half century of investing. Following is one observation.
MOST OF THE TIME STOCKS ARE THE PREFERRED ASSET—BUT NOT ALWAYS.
When the Standard and Poor's 500 Index ("the Index") is selling at its mean CAPE ratio, its expected compound annual return is 8% to 9%—6% to 7% from earnings growth and two percentage points from reinvested dividends. The 10-year U.S. Treasury note yield has averaged 6.4%, albeit with less risk than the Index. Treasury bills yield even less, but with almost no risk. Almost always, the Index outperforms U.S. Treasury fixed income.
However, in late December, 1999, a rarity occurred. The Index was more than 100% overvalued; and zero-coupon Treasury securities, from 5 to 25 year maturities, were yielding 6% to 7%. According to my analysis at that time*, if the Index’s P/E ratio reverted to its mean at any time before each of those 5 year intervals, the Treasury notes and bonds would outperform the Index! At that time the Index was 1435. Following are the results of my study.
Index Index
Mean Reversion Expected Compound Zero Treasuries'
by Year-End Annual Return** Yield to Maturity
2004 -3.3% 6.2%
2009 2,5% 6.5%
2014 4.4% 6.7%
2019 5.4% 6.5%
2024 5.9% 6.4%
**Including reinvested dividends
This year, in early March, the Index reached 2400. Since my study 17 years ago, the Index has compounded at 3.1% annually. Add 2 percentage points for reinvested dividends, and the total compound annual return has been a mere 5.1%—in line with my expectation shown in the table. The bond with that maturity yielded 6.6% at the time of my study—a 29% higher return with LESS RISK.
*This analysis was part of an article published in the December 27, 1999 issue of Barron's.
FUTURE RETURNS FROM HERE
In the same vein, I thought it might be interesting to calculate future total Index returns using the same methodology from 17 years ago. With that in mind, I have calculated what Index returns can be expected if mean reversion occurred immediately, within five years , or ten years. For the Index's mean CAPE ratio, I use my adjusted 19.8. The Index is currently again at 2400.
Index
Expected
Index Compound
Mean reversion Annual Return***
Immediately -33.0%
Within Five Years 0.7%
Within Ten Years 4,8%
***Including reinvested dividends
Were a cataclysmic event to occur, causing immediate mean reversion, the Index would drop 33.0%, to 1600. I would take an out-sized Index position at that price. Mean reversion within five years would result in an expected compound annual total return of a mere 0.7%; and within ten years 4.8%. This compares with a normal 8% to 9% total compound annual return for the Index. $100,000 invested at 4.8% a year reaches $160,000 in ten years; at 8.5%, it reaches $226,000—the beauty of compound growth, the “eighth wonder of the world!”
