Thursday Thoughts
November 10, 2016
Tale of Two Periods has Lessons for Today’s Equity Investors
Last week we reviewed two periods of rising bond yields and the implications for today’s fixed income investors. We
concluded that a period of modestly rising interest rates like that of 1949-1964 can have a surprisingly negative effect on
bond portfolio returns. In fact, returns were similar to the notorious bond bear market over the 1966-1981 period.
This bit of history may have important implications for investors today. It is not unreasonable to assume that bond yields
over the next decade and a half could look much like those of the 1949-1964 period. In that period rates began from a low
base and rose gradually over the ensuing years.
The two periods may also hold lessons for today’s stock market investors. But whereas long term bond returns were quite
similar over the two periods, returns from US stocks diverged dramatically.
Let’s start with total returns over each period. From the beginning of 1949 through year-end 1964, the S&P 500 delivered a
compound annual return of 13.9%. This absolutely trounced the 5.9% from the beginning of 1966 through the end of 1981.1
One guess for the disparity might be that the Post War economic boom resulted in rapid earnings growth, whereas the 1970s
include a sharp recession and gave us the term “stagflation.”
Actually, earnings grew faster in the period that includes the 1970s. It was plunging stock market valuations that led to the
underperformance.
In the accompanying chart it is clear that rising valuations (price-earnings ratios in this case) were a tailwind to rising
earnings over the earlier period. The fact that investors willing to pay more for a dollar of corporate earnings in 1964 than
in 1949 was a key driver of the market’s performance over the 1949-1964 period:
Source: Shiller data and Bloomberg year-end prices
Though this commentary has been prepared from public and private sources believed to be reliable, Ranger International Management, LP makes no warranties or
representations with respect to its accuracy or completeness. Further, the information presented herein is for informational purposes only and should not be construed
in any way as an offer to sell or a solicitation of an offer to buy any securities, investment product or investment advisory services.
Ranger International | 2828 N. Harwood Street, Suite 1900 | Dallas, Texas 75201 | (214) 871-5210 | ranger-international.com
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Thursday Thoughts November 10, 2016
In contrast, falling valuations were a persistent headwind to stock market returns in the 1970s as the accompanying chart
reveals. The amount investors were willing to pay for a dollar of earnings in 1981 was much less than in 1966:
Source: Shiller data and Bloomberg year-end prices
One can the blame shrinking valuations of the 1970s on high (and rising!) interest rates. The real culprit, however, was
inflation, a critical influence on the level of bond yields. Stock market historians have documented the relationship between
inflation and stock market valuations, and in general, the greater the inflation, the lower the valuation. Exceptions to this rule
include periods like the 1930s when deflation takes hold. Much like inflation, deflation depresses stock market valuations.
The table below compares returns from stocks, intermediate and long term bonds, along with inflation. Note that 5-year
Treasuries came very close to matching returns from stocks during the latter period.
Compound Annual Returns and Annualized Inflation
S&P 500
5 Year Treasury
20 Year Treasury
Inflation
Beginning 1949-End 1964
13.9%
2.5%
1.7%
1.6%
Beginning 1966-End 1981
5.9%
5.8%
2.5%
7.0%
Source: IbbotsonAssociates, “Stocks, Bonds, Bills and Inflation”
Given the above, the question for today’s investors is, is this bit of history relevant? To address that rhetorical question, we
present the chart below of earnings and price earnings ratios since year-end 2001.
Source: Bloomberg
Though this commentary has been prepared from public and private sources believed to be reliable, Ranger International Management, LP makes no warranties or
representations with respect to its accuracy or completeness. Further, the information presented herein is for informational purposes only and should not be construed
in any way as an offer to sell or a solicitation of an offer to buy any securities, investment product or investment advisory services.
Ranger International | 2828 N. Harwood Street, Suite 1900 | Dallas, Texas 75201 | (214) 871-5210 | ranger-international.com
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Thursday Thoughts November 10, 2016
With valuations on the expensive side, today’s stock market resembles the environment in 1966. Yet interest rates are near
record lows. From this perspective, the interest rate environment is more similar to 1949. What this means for US stocks
remains to be seen. Current valuations seem to indicate that rising price earnings ratios may not be a key contributor to total
returns over the next several years. Valuations might even drift lower if bond yields rise from today’s ultra-low levels.
With no boost from valuations, it would be up to earnings and dividends to drive total returns for equity investors. An end
to the corporate profits recession may be a boon to stocks in that regard. But with no tailwind from rising PEs, corporate
profits will have to deliver turbo charged growth to deliver returns comparable with the long term averages.
It seems that US total return investors are now faced with the choice of allocating investments between a fairly expensive
stock market and a bond market with yields that are not only low, but they are so low that bond prices are now particularly
sensitive to a rise in interest rates.
But income-oriented investors may see things differently. These may include investors more concerned with the income
generated by their investments than the market value of their assets at a particular moment. Such a perspective may lead these
investors to seek higher yielding equities both here in the US and abroad. Rising interest rates may pressure the valuations of
these higher yielding equities, but they may pressure the valuations of all stocks. The 1970s provided an extreme example
of this relationship. And because bond prices move inversely with yields, rising rates will certainly pressure the valuation
of traditional bonds.
However, a carefully structured portfolio of equities with solid prospects for dividend growth may limit the impact from
lower valuations should they occur. When income accounts for a relatively greater share of total return, changes in market
values have a relatively smaller effect.
Investors soon to enter the distribution phase – the financial planning industry’s term for “retirement” – may very well be
more interested in the income their assets can produce than in predicting their portfolio’s value 10 or 20 years out. With bond
yields low, dividends may continue to play an important role for these income-seeking investors, whether interest rates start
rising this December, the next December, or the next.
Endnotes:
1.
Source: “Stocks, Bonds, Bills, and Inflation,” Ibbotson Associates.
2.
For an in-depth review of historical stock market returns and stock market cycles, see “Unexpected Returns” by Ed Easterling,
published by Cypress House.
3.
“Maybe not dangerous, but stock valuations are still notably high,” WSJ.com, Paul Vigna, 10/11/16
4.
“The profit recession on Wall Street is coming to an end,” CNBC.com, Jeff Cox, 10/10/16.
5.
The lower the bond coupon, the more a bond’s price will be affected by a given change in interest rates, all things equal.
Though this commentary has been prepared from public and private sources believed to be reliable, Ranger International Management, LP makes no warranties or
representations with respect to its accuracy or completeness. Further, the information presented herein is for informational purposes only and should not be construed
in any way as an offer to sell or a solicitation of an offer to buy any securities, investment product or investment advisory services.
Ranger International | 2828 N. Harwood Street, Suite 1900 | Dallas, Texas 75201 | (214) 871-5210 | ranger-international.com
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