Investing

Why Stocks Beat Bonds

Rapid economic growth isn't necessary to generate healthy stock-market returns.

Granted, it's been a rough decade for stock-market investors. But even if you include the past ten years, the long-term return on stocks has been between 6% and 7% per year after inflation. And that return has dominated all other asset classes. Recently, a few investment gurus -- led by Pimco's Bill Gross and Mohamed El-Erian -- have predicted that future returns on stocks will disappoint investors. They've coined the term new normal to represent the slow-growth economy -- and diminished stock returns -- that they believe investors can expect in the future.

But I would take issue with their assumptions. Rapid economic growth isn't necessary to generate healthy stock-market returns. In fact, based solely on current share prices and the market's current earnings power, stocks should be very rewarding for long-term investors.

Projected returns. Stock investors can project their returns using techniques similar to those that bondholders use. A bond promises to pay a fixed coupon year after year, and the expected return on the bond can be expressed as the coupon divided by the price of the bond. Although stockholders do not have a guaranteed coupon, they do have a claim on a company's earnings. As of February 15, the price-earnings ratio of Standard & Poor's 500-stock index, based on estimated 2010 profits, stood at 14.2. If we take that P/E and stand it on its head, effectively calculating the market's earnings-to-price ratio, we get 7.1%. That figure is known as the market's "earnings yield" and represents the return that investors would receive if the companies in the S&P 500 paid out all of their earnings as dividends. That far exceeds the recent yield of 3.7% on a ten-year Treasury note or even 4.6% on a 30-year bond.

Proponents of bonds will point out that although stocks might be projected to earn 7.1%, the market's current dividend yield -- representing the cold, hard cash actually paid to stockholders -- is only 2.1%. However, earnings that are not paid out can be reinvested by management. That alone has helped dividends grow at a 5% annualized rate over the long term. Even if a company lacks opportunities for growth, management can use the excess cash to increase dividends or buy back shares, which should, at least in theory, prop up a stock's price. Any capital gains should be added to the dividend yield to calculate total stock returns.

Even the three- to four-percentage-point difference between stock and bond yields understates the advantages of stocks. Most government bonds aren't adjusted for inflation, so investors receive the same number of dollars in the future as they do today, even if inflation wipes out a substantial part of their purchasing power. In contrast, stocks are claims on real assets, such as land, factories and equipment, as well as the ideas, patents and all other capital that generate corporate profits and appreciate over time with the general level of prices. So that 7.1% yield on stocks can be considered the expected real, or after-inflation, return.

Of course, you can buy Treasury bonds that are indexed to inflation (see Why You Need TIPS). But the current real yield on ten-year Treasury inflation-protected securities is just 1.4%, and 2.1% on 30-year bonds. The projected returns from stocks, at five to six percentage points above those yields, are generous by historical standards.

Skeptics will point out that earnings estimates may not be realized. But in sharp contrast to the past two years, analysts have been aggressively boosting their estimates for 2010 after a near-record number of firms beat projections for the fourth quarter of 2009. And with prospects poor for juicy returns in the bond market, there are good reasons to believe stocks will outpace bonds in the coming year and over the long haul.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.

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