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Think A Correction Is Imminent? You're Still Better Off In Stocks

  • Lofty equity valuations have investors fearful of stocks.
  • Similar to Peter Lynch's Stocks versus Bonds experiment in 1993, I modeled the likely performance of an investment in stocks versus one in bonds through 2025.
  • For investors with a 5- to 10-year time horizon, stocks offer significantly greater returns even in light of a 20% or 25% correction and recessionary slow growth.

(Source: The Prosperity Active Yield Fund)

Abstract:

Low interest rate environments skew the Equity Risk Premium (ERP) as investors are faced with the difficult decision to either chase returns by assuming more risk through equities or to store their cash in incredibly low-yielding fixed income securities. At a time when the S&P 500 Index trades at the highest level it has ever traded and the highest forward P/E multiple in a decade, having more than tripled in value in the last six years all without having faced a twenty percent decline, investing in stocks may seem daunting. If you follow the advice of many financial pundits, you likely believe that a 20% correction comes sooner than later for the stock market. If you've read my article, The Party Isn't Over Yet: Why The Market Should Return 15% By Year-End, you'll know that I disagree and currently expect that the S&P 500 Index has plenty of room for growth in the form of multiple expansion in light of the disparity between the Index's current Ideal P/E multiple and its Forward P/E multiple.

However, many financial talking heads disagree and continue to assert that a correction is imminent. If you are inclined to believe in an impending correction, I have some good news for you: Even if the S&P 500 Index were to fall 20% between now and December of 2015, an investment in the S&P 500 Index today is still likely to significantly outperform an investment in a U.S. 10-Year Treasury over the next ten years. In fact, this remains true even in the event of a 25% correction by year-end and a subsequent low-growth, recessionary environment where the Index grows at half of its historical mean rate.

The Great Stocks Versus Bonds Debate:

Since January 1st, 1950, the S&P 500 Index (NYSEARCA:SPY) has returned an annualized 7.68%. Including reinvested dividends, the Index has experienced an annualized total return of 11.28% over that time (Source: DQYDJ SP 500 Index Return). In Beating the Street, Peter Lynch ran an experiment to display the ability of stocks to outperform bonds even after a significant correction and annual withdrawals consistent with the bond yield. Back in 1993 when the book was written, the U.S. 10-Year Treasury Yield was a plump 7%. Today it yields just 2.17%. Lynch examined three hypothetical portfolios to see how they were likely to perform:

  1. 100% Stocks
  2. 100% Bonds
  3. 50% Bonds, 50% Stocks

(Note: The 50/50 Mix Portfolio only begins as 50% stocks and 50% bonds, it is not readjusted each year to maintain that ratio. By the end of 2025, the ratio has certainly changed.)

I decided to run a similar experiment today using all three portfolios in two stock market correction scenarios. Here are the results:

Current Data:

  1. Current U.S. 10-Year Treasury Yield: 2.17%
  2. Current S&P 500 Index Dividend Yield: 2.01%
  3. Mean annualized S&P 500 Index return since 1950: 7.68%

Assumptions:

  1. Begin with $100,000.00
  2. A 20% correction occurs this year (2015) in the S&P 500 Index
  3. As the current U.S. 10-Year Treasury Yield is 2.17%, $2,170.00 is withdrawn each year from each portfolio to be "spent". In the 100% bond portfolio, this is simply the bond yield. In the 100% stock portfolio, this is the index dividend yield. In the event that the dividend yield results in less than $2,170.00, the remainder is withdrawn from the stock portfolio. In the event the dividend yield results in more than $2,170.00, the surplus is reinvested into the index. In the 50% bonds, 50% stocks portfolio, the dividend yield is added to the bond yield and the remainder (or surplus) is taken from (or added to) the equity portfolio.

Scenario 1:

  • A 20% correction occurs this year in the S&P 500 Index
  • Mean S&P 500 Index returns follow for the remaining years

100% Stocks:

(Source: The Prosperity Active Yield Fund)

  • Total Return: 89.67%
  • Years Until Positive Return: 3
  • Years Until 100% Stocks Outperforms 100% Bonds: 5
  • Years Until 100% Stocks Outperforms 50/50 Mix: 4

100% Bonds:

(Source: The Prosperity Active Yield Fund)

  • Total Return: 26.07%
  • Years Until Positive Return: 0
  • Years Until 100% Bonds Underperforms 100% Stocks: 5
  • Years Until 100% Bonds Underperforms 50/50 Mix: 5

50% Bonds, 50% Stocks:

(Source: The Prosperity Active Yield Fund)

  • Total Return: 56.05%
  • Years Until Positive Return: 3
  • Years Until 50/50 Mix Underperforms 100% Stocks: 4
  • Years Until 50/50 Mix Outperforms 100% Bonds: 5

Scenario 2:

  • A 25% correction occurs this year in the S&P 500 Index
  • A recession follows, resulting in only half of the mean S&P 500 Index returns (3.84% annually) through 2025.

100% Stocks:

(Source: The Prosperity Active Yield Fund)

  • Total Return: 26.84%
  • Years Until Positive Return: 6
  • Years Until 100% Stocks Outperforms 100% Bonds: 10
  • Years Until 100% Stocks Outperforms 50/50 Mix: 10

100% Bonds:

(Source: The Prosperity Active Yield Fund)

  • Total Return: 26.07%
  • Years Until Positive Return: 0
  • Years Until 100% Bonds Underperforms 100% Stocks: 10
  • Years Until 100% Bonds Underperforms 50/50 Mix: 10

50% Bonds, 50% Stocks:

(Source: The Prosperity Active Yield Fund)

  • Total Return: 24.97%
  • Years Until Positive Return: 5
  • Years Until 50/50 Mix Underperforms 100% Stocks: 10
  • Years Until 50/50 Mix Outperforms 100% Bonds: 10

Takeaway:

It is a nervous time for equity holders. With whispers of a stock market bubble, caused in a large part by today's low interest rate environment, many investors are wondering if continued investments in stocks are prudent in light of a seemingly inevitable correction. (Note that I strongly disagree with the idea of an inevitable correction and am in fact anticipating a double-digit return in the S&P 500 Index for 2H15) This article has attempted to show that investing in stocks (as replicated through the S&P 500 Index) even immediately before a significant correction is still likely to outperform investing in bonds in as little as 5 years. Even in a doomsday scenario where the S&P 500 Index crashes 25% and the resulting recession slows the resulting mean annual Index return to just 3.84%, the 100% stock portfolio still performs the best through the end of 2025.

The truth of the matter is that stocks remain the only viable investment opportunity in today's capital markets, despite lofty valuations. Accordingly, I believe that stocks will continue to rise through multiple expansion as prudent investors continue to acknowledge the favorable Equity Risk Premium by picking stocks over bonds. With a 5- to 10-year investment horizon, investors capable of withstanding short-term pressure will almost certainly be rewarded for investing in stocks.


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