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Sunday, November 02, 2008

DeLong: Stocks and the Long-Run

Brad DeLong says if you have the time and resources to ride out the financial storm, now is a good time to buy stocks:

Stocks and the long run, by J. Bradford Delong, Project Syndicate: After the second 40 percent decline in America’s Standard & Poor’s composite index of common stocks in a decade, global investors are shell-shocked. Funds invested, and reinvested, in the S&P composite from 1998-2008 have yielded a real return of zero... Not since 1982 has a decade passed at the end of which investors would have been better off had they placed their money in corporate or United States Treasury bonds rather than in a diversified portfolio of stocks.

So investors are wondering: Will future decades be like the past decade? If so, shouldn’t investments in equities be shunned?

The answer is almost surely no. ... Periods like 1998-2008, in which stocks do relatively badly, are preceded by periods — like 1978-1988 and 1988-1998 — in which they do relatively well, and are in all likelihood followed by similar periods.

Do the math. At the moment, the yield-to-maturity of the 10-year US Treasury bond is 3.76 percent. Subtract 2.5 percent for inflation, and you get a benchmark expected real return of 1.26 percent.

Meanwhile, the ... expected fundamental real return on diversified US stock portfolios right now is in the range of 6 percent to 7 percent. ...

But aren’t stocks risky? ... Couldn’t the market undergo another 40 percent decline in the near future? Aren’t bonds safer? The answers to these questions are yes, yes, yes, and yes.

Remember:... stock market declines that are not accompanied by steep and persistent collapses in earnings are by their nature temporary: they are provoked by steep rises in perceived risk, and if those risks turn out to be overblown, stocks rebound when the perception of risk falls.

And how about stock market declines that are accompanied by a steep and persistent collapse in earnings — by depressions?

In the pre-World War II era, when governments held fast to the gold standard, depressions were times of deflation. But in the post-World War II era,... an earnings depression is much more likely to be accompanied by inflation.

True, a steep and persistent collapse in earnings will erode wealth invested in stocks. But the inflation that accompanies it will produce a steeper and larger erosion of real wealth invested in nominal bonds. As Edgar L. Smith wrote in The Atlantic Monthly back in 1924, when the principal risks are macroeconomic, bonds are no safer than diversified portfolios of stocks — in fact, they are riskier.

All these arguments apply only to long-term investors who can afford to wait out another 40 percent decline in values and keep their money invested until perceived risk drops. (And if perceived risk never drops than you have worse things to worry about than the performance of your portfolio.) For retirees and other people who need to spend soon, the year-to-year variability of the stock market commands caution.

But for those who do not need to spend soon, the recent decline in equity values is more an opportunity than a catastrophe. We liked the stocks in our portfolio a year ago for their long-term prospects. Today’s short-term crisis does not materially alter their long-term prospects. And now we have an opportunity to buy more, and cheaply.

    Posted by on Sunday, November 2, 2008 at 05:49 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (22)


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