The case for the 20,000 Dow

Individual and institutional investors alike have been shifting their capital from stocks to cash and bonds at a rapid rate in recent years, despite extraordinarily low interest rates. We think that 10 years from now, investors will wish they had stayed in stocks, or added to them.

It’s tempting to give up on stocks after more than a decade of high volatility and low returns from stocks — and lower volatility with higher returns from bonds. Even some experts argue that the world has entered a “new normal” condition in which stocks have permanently lost their return edge. We’ve heard this before. It was wrong then, and we think it’s wrong now, too.

As the ubiquitous legal disclosure says, past performance does not guarantee future returns. Indeed, performance often reverses sharply.

Between 1901 and the onset of the recent credit crisis, there have been 11 10-year rolling periods in which bonds beat stocks, all of them coinciding with the Great Depression or the stagflation of the 1970s. And after each and every one of them, stocks beat bonds for 10 years — on average, by 5.8 percent.

It takes guts to buck the trend. But at a September 1983 client conference, we cited good fundamental reasons in making “the case for the 2,000 Dow.” The Dow Jones Industrial Average was then slightly below 1,300. It reached 2,000 in January 1987, about three and a half years later.

Today, our median annual return projections for global and U.S. stocks are about 8 percent over the next 10 years, far ahead of our projected 2 percent median return for 10-year Treasurys. At that rate, the Dow could hit 20,000 in five to 10 years. In the same time frame, the S&P 500, a more representative index, could hit 2,000. (It’s now around 1,300.)

Our projected stock returns may sound optimistic. They’re not. They are well below the long-term average for U.S. and global equities and based on conservative assumptions about economic and market conditions. Bonds, on the other hand, are unlikely to outpace inflation, because current yields are extremely low.

Are stocks expensive?

We recognize that the U.S. and global economies continue to be scarred by the credit crunch that began in 2008. Significant risks remain, particularly in Europe.

The global economy may take several more years to fully recover from the credit crunch, and so may the stock market. Both could weaken again before getting better. Our research has found that after 15 prior systemic banking crises around the world, the stock market took nine years, on average, to regain its prior peak. We don’t know if the recovery from the recent crisis will take a longer or shorter time than average, but assuming it is average, we’re now about halfway through.

But even taking these risks into account, we don’t agree with those who argue that the stock market is overvalued. To begin with, it doesn’t make sense to say the market is expensive, given where bond yields are today.

Low bond yields tend to reduce companies’ borrowing costs. They also drive up the present value of future earnings and dividends, and they make bonds a less appealing alternative to stocks. High bond yields, by contrast, drive up companies’ borrowing costs, reduce the present value of their future earnings and dividends, and make bonds more appealing relative to stocks.

What this means for you

All this has important implications from the point of view of your long-term investment goals.

Despite low yields, bonds should still play their usual roles in your portfolio: providing income, preserving capital and providing protection in times of stock market distress (because bond prices tend to rise at such times).

Most investors are likely to need stocks to feel confident that they will have enough to live on. Remember, volatility isn’t the only type of risk. There’s also shortfall risk — not having enough money to meet your spending requirements. Investors must weigh both types of risk when making strategic asset allocation decisions.

In sum, highly uncertain macroeconomic conditions make large stock market drops more likely than usual, and very low bond yields provide a thinner cushion. As a result, market risk can’t easily be avoided. And trying to avoid market risk is not a good strategy if it increases shortfall risk too much. A 20 percent loss is certainly painful, but it doesn’t hurt as much as running out of all of your money.

Tresse is principal and adviser at Bernstein Global Wealth Management.

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