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Despite history, stock market is a gamble

Over the long run, stocks have produced a 7.2 percent return after inflation. But there is no crystal ball - or guarantee.

By HELEN HUNTLEY
Published March 13, 2005

Can the stock market save Social Security? How about your retirement plan?

President Bush's proposal for private Social Security accounts is built on the assumption that stocks will continue to be long-term winners. Your company's pension plan and your personal financial plan - if you have them - are probably counting on the same thing.

Many of us have run the numbers: save so much each payday, put most of it in stocks, and in 30 years we'll be retired and living the good life.

But is that realistic or just wishful thinking?

History tells us that stocks have been stellar performers over the long run, producing a 7.2 percent "real" return, which is what you get after subtracting inflation. Government bonds have beaten inflation by more than 2.3 percent long term, and cash has returned a little less than 1 percent. Inflation averaged a little more than 3 percent over that period.

Of course, the markets don't make that much money for everyone. Reports of stock market returns are always based on a broad market index, usually the Standard & Poor's 500 Index, and don't take taxes into account. Many individual stocks will have done better, many worse.

In addition, a crucial element in all reports of long-term returns is keeping your money invested for decades. Stocks were a lousy investment for much of the 1970s and a terrific one in the 1990s.

"The markets go every which way, but we've done some analysis . . . over any 40-year period, the equity returns will far exceed Treasury bonds and they'll be very highly positive," Treasury Secretary John Snow said during a recent Tampa Bay visit.

Social Security actuaries are projecting a real return of 4.6 percent a year for a mixed portfolio of stocks and bonds, which assumes a 6.5 percent annual return for stocks.

That's certainly within historical norms, and some people see those numbers as perfectly fine for long-range planning.

T. Rowe Price uses a real return for large stocks of about 7 percent - 10 percent minus 3 percent for inflation - said Ned Notzon, chairman of the mutual fund company's asset allocation committee.

"We don't see any reason to think that going forward the next 30 to 40 years will be a lot different," he said.

However, others say you can't count on history and it's likely future returns will be lower.

"I've never bought the argument that stocks are going to outperform just because they always have," said Scott Brown, economist for Raymond James & Associates in St. Petersburg.

A group of economists polled by the Wall Street Journal projected an average real return of 4.8 percent for stocks and 2.8 percent for government bonds over the next 44 years. If they're right, young workers still would be better off choosing private accounts, but they wouldn't have much margin for error. Under the president's plan, a real return of 3 percent is the break-even point to offset the reduction in benefits that would come with the private accounts.

"Stocks should beat bonds on average, but everybody's taking more risk, so it's not guaranteed that you'll come out ahead," said Roger Ibbotson, a management professor at Yale University and chairman of Ibbotson Associates, which tracks and analyzes investment returns.

His own long-range forecast is for a real return of 5 to 6 percent for stocks and 1 to 1.5 percent for bonds.

In the long run, stock prices are a function of two things: expectations for future corporate earnings and how much investors are willing to pay for each dollar of earnings.

Earnings, a company's net income, are tied to a large extent to the economy, which grows as the population increases and worker productivity improves.

As a result, the first of the two critical elements of the stock price can vary as widely as the estimates on economic growth. Although real economic growth has been about 3.3 percent over the past 40 years, Social Security actuaries project it will slow to 2.9 percent through 2013 and then to an anemic 1.8 percent for 2015 through 2080, primarily because of the aging of the population.

The pessimistic outlook on the economy also is one of the assumptions behind the actuaries' estimate that Social Security will run out of money to pay full benefits in 2042.

"If growth really is that slow, it is very hard to see how the real rate of return on equities could be as high as 6.5 percent," said a report by global economics researchers at Goldman Sachs. It said a 3.5 percent real return would be more realistic under those circumstances.

If the actuaries are right about the economy, we should expect lower returns from the stock market, economist Brown said.

However, he and others point out that forecasts aren't always right. An increase in immigration or a trend toward later retirement would produce stronger economic growth. In addition, many companies do business globally, so their earnings aren't as closely tied to the U.S. economy.

"If a foreign economy is booming far beyond ours, money will flow there," Clearwater financial planner Ray Ferrara said.

University of Central Florida finance professor David Scott calls the Social Security actuaries' forecast "ridiculously low." He says the U.S. economy will benefit from the boom in China in the decades ahead: "There will be tremendous demand for U.S. goods and services and knowledge."

The other half of the stock return equation - what investors are willing to pay for a dollar of earnings - is even more difficult to forecast. Currently investors pay about $21 for every $1 of earnings for stocks in the Standard & Poor's 500 index. The historical average - since 1935 - is a little more than $15 for every $1 of earnings. That doesn't mean stock prices are inevitably headed lower. But it does mean that we've already seen a big increase in what investors were willing to pay for a dollar of earnings.

"Part of the historical return was a windfall that you won't get twice," Yale professor Ibbotson said.

Just as stock prices have risen faster than earnings, they also have risen faster than companies have increased their dividend payouts. The lower yields of today imply dividends will be a less significant part of total returns going forward than they have been in the past.

The price investors are willing to pay for a dollar of earnings can fluctuate widely. Market psychology sometimes produces major moves such as the frenzy over tech stocks that drove the Nasdaq Stock Market to unsustainable levels, then sent it crashing. At the peak, investors were paying $246 for $1 of earnings for stocks in the Nasdaq 100. They're now paying about $30.

A steadier increase in demand has come from the increase in the popularity of 401(k) retirement savings plans and the growing recognition that workers need to save for their retirements. Some people worry that situation will reverse as the baby boomers enter retirement and sell stocks to generate income.

One reason stocks are attractive to investors now is that interest rates are low on competing investments.

"Once you get long bonds above 8 percent, you generally start to see a big move out of equities into bonds," said St. Petersburg money manager Timothy McIntosh. His own prediction is that rates will stay below that and stocks will continue to do well.

One thing that could drive rates higher is a big increase in government borrowing, should that become the way the government decides to cover the projected shortfall in funding for Social Security and Medicare.

Even small differences in returns over many years of investing make a big difference in how much money you have in retirement. If you save $3,000 a year for 30 years, you'll accumulate $283,838 with a 7 percent return, but just $199,317 with a 5 percent return.

The reason stocks return more than bonds and cash is that they require investors to take more risk. There is always the chance of loss, as well as gain.

"If things go well and you leverage up and buy more stocks, you definitely can cure the (Social Security) problem," Yale professor Ibbotson said. "But it is a bet on things going well."

Helen Huntley can be reached at 727 893-8230 or huntley@sptimes.com

[Last modified March 13, 2005, 00:21:06]