Reversion to the Mean May Be Good, Not Mean

It’s official. The stock market has been a terrible place to be. And not just for a few years, but for decades.

New research from the Leuthold Group, a Minneapolis-based institutional research and mutual fund firm, indicates that stocks have done about as poorly relative to 10-year Treasury obligations as they have ever done.

Yes, you read that right. Ever.

I am not telling you this to rub it in. You don’t need to be told that stocks have done poorly for more than a decade.

But knowing exactly how terrible the return on stocks has been relative to bonds may also tell us something about the future. Stocks are more likely to provide higher returns than bonds in the future simply because no extreme lasts forever.

Here’s what Leuthold Group researcher Eric Bjorgen did. Taking quarterly data from every period since 1926, Bjorgen compared the performance of stocks, as represented by the S&P 500 index, with the performance of 10-year Treasury obligations over the same time period. He did this for every trailing 12-month period, for every trailing 3-year period, and for trailing periods out to 50 years. Then he examined the distribution of the performance differences, using histograms.

What he found confirmed some old knowledge. It also revealed how extreme the misery of the current market is.

The old knowledge confirmed:

  • Stocks provide higher returns than bonds most of the time. Over 333 one-year periods since 1926, stocks have provided higher returns than 10-year Treasury obligations 212 times, or 63.7 percent of the time.
  • The longer you hold stocks, the greater the odds your return will be better than the return on 10-year Treasury obligations. While stocks beat bonds 63.7 percent of the time over 12-month periods, they beat them 77.2 percent of the time over 5-year periods, 85.3 percent of the time over 10-year periods, 99.1 percent of the time over 25-year periods, and 100 percent of the time over periods of 35 years or more (see chart below).

The new knowledge of just how bad the current period is:

  • While stocks did better than bonds by 6.6 percentage points a year, on average, in 12-month periods, they trailed by a near record 47.8 percent in the most recent 12-month period ending March 2009. Only 2 of 333 time periods were worse.
  • The record is nearly as dismal over all 3-year periods. Only 8 of 333 time periods were worse.
  • The same result is shown for all 5-, 10-, 15-, 20-, 25-, 30-, 35-, 40- and 50-year time periods. In each case, the return on stocks relative to bonds is at near record lows. Note that this doesn’t mean stocks lost money and bonds made money. It simply means that in recent periods, stocks have returned less than bonds by the greatest historical margin.

There are two ways we can respond to this.

One is to believe that everything we know is wrong and history is being written. Bonds are better investments than stocks today, and for the future.

The other is what the Leuthold Group researchers believe. This is a time to buy stocks (or at least continue holding them) because extremes like this simply don’t go on forever. There is always reversion to the mean.

That reversion can also mean a powerful future return. Examining the subsequent returns on stocks in comparable extreme periods, for instance, the researchers found stocks always beat bonds in future periods. Over all subsequent 5-year periods, for instance, they found that stocks returned 19.5 percent--- nearly double the historical average.

The future may not be nearly as bleak as it seems.

Long Term, Stocks Beat Bonds

This table shows the percentage of time stocks beat bonds in the 333 quarterly periods from 1926 through the first quarter of 2009. Stocks are represented by the total return of the S&P 500 index, and bonds are represented by 10-year Treasury obligations.

Holding Period Percentage of Time Stocks Beat Bonds
(Measured Quarterly)
One year 63.7%
Three years 70.0
Five years 77.2
Ten years 85.3
Fifteen years 92.5
Twenty years 97.6
Twenty-five years 99.1
Thirty years 99.7
Thirty-five years 100.0
Forty years 100.0
Fifty years 100.0

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