Earning Biases: Up and Down
The accounting treatment of pensions and employee stock options overestimates corporate earnings. But there are accounting conventions that work in the opposite direction.
For example, research and development costs are routinely expensed although there is good reason to capitalize these expenditures and then depreciate them over time. This means that the reported earnings of firms with a high level of R&D expenditures, such as the pharmaceutical industry, may be understating their true earnings.
Take Pfizer, the largest drug stock in the world and one of the five largest companies in the S&P 500 in 2004. In 2003, Pfizer spent $7.6 billion on research and development for drugs and almost $3 billion on plants and equipment. Governed by current accounting rules, Pfizer deducted from its earnings 5 percent of the $3 billion it spent on plant and equipment as depreciation, as the remainder would be deducted over the useful life of these assets.
But 100 percent of the $7.6 billion Pfizer spent on research and development was deducted from its current earnings. This is because Pfizer’s R&D is not considered an “asset” in accounting and must be expensed when the expenditures are made
Does this make sense? Is Pfizer’s R&D less of an asset than its property, plants, and equipment? Considering Pfizer’s value largely stems directly from the patents it gains through its research and development expenditures, this accounting treatment seems to cast too negative a shadow on Pfizer’s performance.
Leonard Nakamura, an economist at the Federal Reserve Bank of Philadelphia, concurs. He stated, “It’s really those [R&D] expenditures that are going to drive long-run corporate performance.”11 Current earnings practices understate the future earnings potential of industries with extensive research and development.
Another understatement of earnings comes from the treatment of interest expenses. Full interest expenses are deducted from corporate earnings even though inflation, which raises interest costs, causes a corresponding reduction in the real value of corporate debt. In inflationary times, the impact of rising prices on fixed corporate liabilities could be substantial.
The bottom line is that not all conventional accounting practices overstate corporate earnings.
A Final Word and a Look to the Future
This chapter evaluates corporate earning practices. While it is true there is some “fluff” in reported earnings, on balance, the earnings data for the entire economy are not materially misleading.
The inherent ambiguities in calculating earnings support the case for paying close attention to dividends. If a firm pays a dividend, you know what you are getting. It is much harder to fake a dividend payment than it is to misrepresent an earnings statement.
Although there is much justifiable concern about management manipulating earnings data, before we shake our fingers at these companies, we should know that the U.S. government plays accounting tricks with its pension programs that would never pass muster with any corporation or regulatory body. Social Security and Medicare have unfunded liabilities that measure in the tens of trillions of dollars, dwarfing those of the corporate sector. These shortfalls pose a much larger risk for our economy than underfunded corporate pension plans and are the subject of the next section of this book.
PART FOUR
The Aging Crisis and the Coming Shift in Global Economic Power
CHAPTER TWELVE
Is the Past Prologue?
THE PAST AND FUTURE CASE FOR STOCKS
I have but one lamp by which my feet are guided, and that is the lamp of experience. I know no way of judging of the future but by the past.
—Patrick Henry, 1775
Paul Samuelson, a Nobel Prize-winning economist and my graduate-school mentor, once said, “You have but one sample of history.” And the history that we have all lived through is replete with twists and turns that would never be repeated if we could run the world again.
Yet history is all we have. And history must have value, since our brains are programmed to learn by observing the past. Studying how markets have reacted to past events gives us insights into how they will behave in the future.
It is with these thoughts in mind that in the early 1990s I began collecting long-term historical data on U.S. stocks and bonds with the goal of discerning whether there were any trends that I could use to predict future returns. The data I analyzed showed that since 1802, the after-inflation rate of return on a diversified portfolio of common stocks was between 6.5 and 7 percent per year over all long-term periods. This finding served as the foundation of my book Stocks for the Long Run. There I wrote:
The long-term stability of these returns is all the more surprising when one reflects on the dramatic changes that have taken place in our society during the last two centuries. The United States evolved from an agricultural to an industrial economy and now to a postindustrial service- and technology-oriented economy. The world shifted from a gold standard to a paper money standard. And information, which once took weeks to cross the country, can now be transmitted instantaneously and broadcast simultaneously around the world. Yet, despite mammoth changes in the basic factors generating wealth for shareholders, equity returns have shown an astounding persistence.1
But looming in the future are changes more fundamental and long-lasting than all the crises that have confronted our economy in the past. The “astounding persistence” of long-term equity returns that I referred to above is threatened by an unprecedented demographic realignment—the age wave—that will soon impact the world economy. The dramatic increase in the number of retirees and the pending sale of trillions of dollars of stocks and bonds threatens to crush asset prices and drown the baby boomers’ hopes of a comfortable and lengthy retirement.
Before analyzing the reality of this threat, it is important to review the historical case for equities in light of new historical data.
Historical Asset Returns
Figure 12.1 is the single most important graph that I have produced from my past studies of financial market returns. It displays the total cumulative return (including capital gains, dividends, and interest) on stocks, long-term government bonds, Treasury bills, gold, and the dollar over the last two centuries after the effects of inflation have been removed.
A single dollar invested in stocks in 1802 grows to $597,485 of purchasing power by the end of 2003, far ahead of the $1,072 in bonds or $301 in Treasury bills. And a single dollar of gold bullion, an asset so beloved by many investors, would be worth only $1.39 two centuries later after the effects of inflation are removed. The cumulative effect of inflation has been substantial; the dollar that we hold today can buy only 7 cents’ worth of what it commanded two centuries earlier.
The dominance of stocks over other assets is overwhelming. Swings in investor sentiment, as well as political and economic crises, can throw stocks off their long-term path, but the fundamental forces generating economic growth have always enabled equities to regain their footing. Despite our history of depressions, wars, financial panics, and most recently the terrorist attacks and scandals that we faced in 2001 and 2002, the resiliency of stock returns is indisputable.
FIGURE 12.1: TOTAL REAL RETURN INDEXES 1802–2003
Siegel’s Constant: 6.5 to 7 Percent Real Equity Returns
The most important statistic culled from these data is the long-term average after-inflation rate of return on stocks. That return has ranged between 6.5 and 7 percent over all long-term periods examined. This return means that investors’ wealth, measured in purchasing power, has doubled on average every decade over the last two centuries in the stock market.
It matters not if you take the early period of U.S. economic development, from 1802 to 1870; the middle period, from 1871 to 1926, when comprehensive data on stock returns, dividends, and earnings became available; the period since 1926, which includes the worst stock crash and the Great Depression; or even the period since the end of the Second World War, when all the inflation our country has suffered ha
s occurred. Real stock returns during all these periods remained between 6.5 and 7 percent. No other asset—not bonds, not Treasury bills, not gold, and certainly not the dollar—displays anywhere near the constancy of the real return on stocks.
I was flattered when Andrew Smithers, a British money manager, and Stephen Wright, a professor at Cambridge University, authors of Valuing Wall Street, named the long-run equity return “Siegel’s constant.” They found it remarkable, just as I had, that this return has persisted through the radical transformations of both the American economy and society over the past two centuries.
The reason why the real equity return falls just short of 7 percent is not well understood. Certainly the returns on stocks are related to the growth of the economy, the quantity of capital, the liquidity of stocks, and the risk premium required by investors.
The return on fixed-income assets, the major competitor to stocks in investors’ portfolios, told a very different story. Instead of a constant real return, the after-inflation return on bonds had steadily declined over the last two centuries. During the entire 200-year period, average annual real bonds returns, at 3. 5 percent, are barely one-half of real stock returns. Treasury bills and other short-term money market assets averaged 2.9 percent real return, while gold managed a bare 0.1 percent return above the rate of inflation.
The Equity Risk Premium
What accounts for the premium return that stocks earn over bonds? At the most basic level, stock market returns depend on the willingness of investors to abandon the short-term safety of fixed-income assets and assume the risk of stock investing.
Such risks will not be undertaken freely. Investors must be compensated to take on risk, to give up, as the proverb says, a bird in the hand today for the chance to obtain two in the bush tomorrow. The extra return that stocks earn above safe investments, such as government bonds, is called the equity risk premium.
Over the past two hundred years, the equity risk premium has averaged about 3 percent.
Mean Reversion of Equity Returns
Very few disagree that stocks have higher returns than bonds in the long run. But many still shun stocks because of their higher volatility. Yet the risk of stocks is critically dependent on the time period over which you hold equities.
Go back to Figure 12.1. A statistical trend line has been drawn through the cumulative stock returns. Note how closely real stock returns cling to the trend line. This tendency of the stock market to follow the trend indicates what statisticians call the mean reversion of equity returns. Mean reversion refers to a variable that can be quite volatile in the short run but far more stable over longer periods. An example of a mean-reverting series is average rainfall, which can vary substantially day to day but is far more stable month to month.
Mean reversion completely changes the way that investors should look at risk. This is shown in Figure 12.2. The bars in Figure 12.2 show the risk (measured as the standard deviation) of the average after-inflation returns of stocks, bonds, and Treasury bills over all one-, five-, ten-, twenty-, and thirty-year periods from 1802 through 2003.
Over short periods, stocks are undoubtedly riskier than bonds. But as the holding period increases to between fifteen and twenty years, the riskiness of stocks falls below that of fixed-income assets. And over thirty-year periods, stock risk falls to less than three-quarters that of bonds or bills. As the holding period increases, the risk of average stock returns falls nearly twice as fast as fixed-income returns.
The reason for this surprising result is the instability of the rate of inflation. Inflation afflicts real bond returns far more than real stock returns. Bonds are promises to pay dollars, not goods or purchasing power. Only recently has the U.S. Treasury issued inflation-indexed bonds that adjust bond return for inflation, but these bonds constitute a small fraction of the total fixed income market.
Stocks, on the other hand, are claims on real assets, such as property, machines, factories, and ideas. Over time the price of these assets will rise with inflation. The behavior of equity returns confirms that over long periods of time, stocks fully incorporate realized inflation, while bonds, by their very nature, cannot.
This evidence supports the proposition that stocks, with their superior returns and lower long-term risk, should be the cornerstone of all long-horizon portfolios. Bonds are demanded by those wanting refuge from the short-term volatility of the stock market and therefore offer much lower returns. But bonds do not hedge the inflation risk that is inherent in our paper money economy, where long-term changes in the price level are unpredictable.
FIGURE 12.2: AVERAGE ANNUAL RISK OF AFTER-INFLATION RETURNS
Worldwide Equity Returns
When I published Stocks for the Long Run in 1994, some economists questioned whether my conclusions, drawn from data from the United States, might overstate equity returns measured on a worldwide basis.
Several economists emphasized the existence of a survivorship bias in international returns, a bias caused by the fact that long-term returns are intensively studied in successful equity markets, such as the United States, but ignored in markets such as Russia or Argentina, where stocks have faltered or disappeared outright.2 This bias suggested that stock returns in the United States were unique and perhaps historical equity returns in other countries were lower.
Three U.K. economists examined the historical stock and bond returns from sixteen countries over the past century and put to bed concerns about survivorship bias. Elroy Dimson and Paul Marsh, professors at the London Business School, and Michael Staunton, director of the London Share Price Database, published their research in a book entitled Triumph of the Optimists: 101 Years of Global Investment Return. This book provides a rigorous yet readable account of worldwide financial market returns in sixteen separate countries.
Despite the major disasters visited on many of these countries, such as war, hyperinflation, and depressions, all sixteen countries offered substantially positive, after-inflation stock returns. Furthermore, fixed-income returns in countries that experienced major wartime dislocations, such as Italy, Germany, and Japan, were decidedly negative, so that the superiority of equities relative to other financial assets was decisive in all countries.
Figure 12.3 shows the average annual real stock, bond, and bill returns of the sixteen countries analyzed from 1900 through 2003.3 Real equity returns ranged from a low of 1.9 percent in Belgium to a high of 7.5 percent in Sweden and Australia. Stock returns in the United States, although quite good, were not exceptional. U.S. stock returns were exceeded by the returns in Sweden, Australia, and South Africa. And the average real return on stocks worldwide is not far from the U.S. return.4
When all the information was analyzed, Triumph of the Optimists concludes “that the US experience of equities outperforming bonds and bills has been mirrored in all sixteen countries examined.… Every country achieved equity performance that was better than that of bonds. Over the 101 years as a whole, there were only two bond markets and just one bill market that provided a better return than our worst performing equity market.”5
Furthermore, “While the US and the UK have indeed performed well … there is no indication that they are hugely out of line with other countries.… Concerns about success and survivorship bias, while legitimate, may therefore have been somewhat overstated [and] investors may have not been materially misled by a focus on the US.”6
This last statement is of extreme importance. More studies have been made of the U.S. equity markets than of any other country in the world. Dimson, Staunton, and Marsh are saying that the results found in the United States have relevance to all investors in all countries. The superior performance of U.S. equities over the past two centuries is not a special case. Stocks have outperformed fixed-income assets in every country examined, often by an overwhelming margin. International studies have reinforced, not diminished, the case for equities.
FIGURE 12.3: REAL RETURNS ON INTERNATIONAL STOCKS, BONDS, BILLS, 1900–2003
Is the Past Prologue?
Despite stocks’ outstanding historical record, there are those who claim that looking at the past can be positively misleading. They claim that the most optimistic case for stocks, or in fact for any asset class, is always made at the absolute top of the market, when the returns looking backward are so good but returns looking forward are so abysmal.
There is much truth to this argument. For example, the past returns on Japanese stocks were extraordinary if measured in December 1989, when the Nikkei average hit 39,000. In the 1980s, annual returns on Japanese stocks soared to nearly 30 percent per year, and international portfolios based on historical risk and return analysis allocated a large fraction to Japanese stocks, particularly the Japanese banking sector. But the Japanese market was on the verge of a great bear market; fourteen years later, the Japanese stocks were less than one-quarter of their level at the market peak. Similarly if you examined historical returns of U.S. market sectors in January 2000 and extrapolated the lessons of the past, all your money would no doubt be put in Internet stocks that had stratospheric returns. Two years later, you would be lucky to be left with ten cents on your dollar.
The Demographic Challenge
Are these wrongheaded predictions happening again? Will the case for equities be destroyed by baby boomers who will soon begin to sell their stocks and bonds?
Robert Arnott, editor of the Financial Analyst Journal whose skepticism about earnings I noted in Chapter 11, flatly stated that the 2000–2002 decline was just the first roar of a long bear market. Arnott said:
The Future for Investors Page 18
