For long-term investors, stocks are the only option

Robin writes:

I was talking to a financial adviser this morning who is seriously concerned about inflation. Across the world, the spending taps are fully on. Governments are spending money on a scale last seen in the two world wars. In both of those cases, the spending was followed by spiralling inflation. My adviser friend is convinced that we’re heading that way again.

I don’t know nearly enough about macro economics to comment on whether he is right to be so gloomy. But I do know that rising inflation is bad news for anyone who is saving or investing for the long term. If your portfolio isn’t delivering more than inflation, it’s declining in value in real terms.

So, what does a long-term investor do? It might feel rather uncomfortable to be investing in equities in the current economic climate. But, as JONATHAN CLEMENTS explains, with cash and bonds effectively providing negative returns, there really is no alternative.

It’s a scary time to own stocks. But for long-term investors who want their portfolio to clock significant gains, there’s simply no alternative.

To be sure, you could throw in your lot with the market-timing crowd, who are currently hiding out in bonds and cash investments. Their plan: When we get the final climactic plunge in share prices that sends the market back to valuations not seen in four decades, they’ll swap into stocks and ride the next bull market to astonishing wealth.

But for the rest of us — who don’t have nearly as active a fantasy life — the best bet is to hang tough in stocks with the bulk of our long-term investment money. Why? Consider the three major asset classes.

Bonds pay nothing

When you buy a bond or bond fund, the best guide to your likely return is the current yield. Just purchased a 10-year Treasury note yielding 0.7%? If you sell before maturity, you might make more or less than 0.7% a year. Still, that 0.7% is the best guide to your future return.

If you opt for bonds of lower credit quality, you’ll get higher yields and that should translate to higher returns. But there’s also an increased risk of defaults, especially if you dabble in bonds deemed below investment grade.

Bond yields should bear some relationship to nominal GDP growth. Why? Corporations will only borrow if they think they can earn a return that’s greater than the interest rate they pay—and that return should, on average, bear some relationship to the rate of economic growth. As the economy recovers, so too will demand for borrowed money and that’ll likely drive interest rates higher.

Those higher interest rates will push down the price of existing bonds, so today’s bond investors could be in for a rough ride as the economy recovers. But it isn’t all gloom: Bond holders will be able to reinvest their interest payments, as well as any new savings, at those higher interest rates. Indeed, if your time horizon is similar or longer than your bond portfolio’s duration, rising interest rates should bolster your long-run return, thanks to that chance to reinvest at higher yields.

Cash is trash

While bond yields tend to track nominal economic growth, the yield on cash investments is more closely tied to inflation—or, at least, inflation as anticipated by the Federal Reserve. And right now, the Fed has no worries about inflation. Instead, its focus is on reviving the economy, which is why the Fed has cut short-term interest rates pretty much to zero.

That means minimal returns on savings accounts, money market funds and other cash investments. What about longer-term inflation? Based on the difference between the yield on 10-year Treasury notes and that on 10-year inflation-indexed Treasurys, investors expect around 1% annual inflation over the next 10 years. That’ll mean continued meagre returns for cash investors.

Still, that shouldn’t surprise anyone. Even when yields on cash investments have been much higher, investors have almost always ended up losing money, once inflation and taxes have taken their toll.

Stocks for the long run

What will stocks return? I fall back on the admirably simple method favoured by Vanguard Group founder John Bogle. To forecast the stock market’s “investment” return, Jack would add the S&P 500’s current dividend yield to expected growth in earnings per share.

Right now, the S&P 500 is yielding 2.1%. Meanwhile, over the next 10 years, nominal GDP might climb 4% a year—that’s what we got over the past 10 years—and it would be reasonable to assume that earnings per share will increase at a similar rate. Add those two together and we’d get the S&P 500 clocking just over 6% a year over the next decade.

To this “investment” return, we need to consider a third factor—what Jack called the market’s “speculative” return, as reflected in the rise or fall in the S&P 500’s price-earnings (P/E) multiple. Guessing what will happen to the market’s P/E ratio is always a dicey endeavor, and it’s especially dicey right now.

It isn’t just that investors seem to be terrified one moment and exuberant the next. On top of that, we’re likely to see P/E ratios soar in the short term, as the economic contraction slams corporate profits. We could also see significant dividend cuts. The key is to look beyond this short-term chaos and focus on the decade ahead. And if we do that, I think it’s reasonable to expect something close to that 6% a year investment return.

Could stocks also get a lift from rising P/E ratios? It’s possible. Today, the S&P 500 companies are trading at 21 times 2019’s reported earnings. That compares to a 50-year average P/E ratio of 19.4 times trailing 12-month reported earnings and a 25-year average of 25.1. But even without rising P/Es, notching 6% a year looks pretty attractive when you consider the alternative—next to nothing on both bonds and cash investments. Convinced? Keep these three points in mind:

— Even if stocks are the best bet for the decade ahead, don’t ignore your risk tolerance and your near-term need for cash. Bailing out of stocks at the wrong time could devastate your wealth.

— Stocks may deliver 6% a year, but your return might be far different—if you aren’t diversified. And the best way to get that broad diversification is (here he goes again) by owning a total U.S. stock market index fund and a total international stock market index fund or, alternatively, by purchasing a total world stock market index fund, such as those offered by State Street’s SPDR and Vanguard Group.

— If you buy total market funds, you’ll enjoy rock-bottom annual investment costs. But don’t forget about the other big subtraction: taxes. With that in mind, trade sparingly in your taxable account, so you don’t trigger big capital gains tax bills, and make the most of the retirement accounts available to you.