About two weeks ago in a post entitled “We Have Some Bearish Bloggers Out There“, Bill Rempel wrote, “Personally, I’m in the ‘extraordinary claims require extraordinary proof’ camp.” I’d like to think I am too, because Bill is right – extraordinary claims do require extraordinary proof.
So, before making any extraordinary claims about future long-term market returns (i.e., predicting future returns that differ substantially from historical returns), I’d like to spend this post laying out the case for why current circumstances are extraordinary. After all, extraordinary times call for extraordinary claims.
Essentially, this is a post about why the present is unlike the past and what that means for the future.
In a previous post, I wrote:
Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.
Unless they internalize this fact, investors risk assuming that historical returns that existed under special circumstances can continue to serve as a useful frame of reference, even when these special circumstances no longer exist.
Later in this post, I will discuss the possibility of a “paradigm shift” (i.e., a change in basic assumptions within the theory of investment) that began in 1995. The only other period in the 20th century which saw similar upheaval in investment thinking was the 1920s.
Common Stocks as Long Term Investments
That theoretical crisis (and the higher valuations that followed it) has often been partly attributed to a thin volume published in 1924 by Edgar Lawrence Smith. The book was called “Common Stocks as Long Term Investments” and it was based on a study of 56 years of market data (1866 – 1922).
Smith found that stocks had consistently outperformed bonds over the long run. Neither the data in support of this conclusion nor the logical explanation for this outperformance (public companies retain earnings and these retained earnings lead to compound growth) was wrong.
However, a few years after Smith’s book was published, the special circumstances of the past disappeared as stocks (which had historically had higher yields than bonds) saw their prices surge and their yields plunge. Soon, stocks had lower yields than bonds – part of the reason for their past outperformance (the initial yield advantage) was gone and the margin of safety which a diversified group of stocks had offered over bonds narrowed considerably.
Simply put, circumstances changed. John Maynard Keynes saw this possibility when he reviewed Smith’s book in 1925:
“It is dangerous…to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.”
That has been the objective of this little study from the outset. In this post, I will focus on how the circumstances of the present differ from the circumstances of the past.
I will also endeavor to demonstrate that historical returns were the result of special circumstances, which (logically) need not apply now or in the future. The historical data suggests these circumstances may yet …Read more