<s> STOCKS FOR THELONG RUN
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F o u r t h
E d i t i o n
STOCKS FOR THELONG RUNThe Definitive Guideto Financial MarketReturns and Long-TermInvestment Strategies
JEREMY J. SIEGELRussell E. Palmer Professor of FinanceThe Wharton SchoolUniversity of Pennsylvania
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Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. All rights reserved. Manufactured in the United States of America. Exceptas permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any formor by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.0-07-164392-3The material in this eBook also appears in the print version of this title: 0-07-149470-7.All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of atrademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention ofinfringement of the trademark. Where such designations appear in this book, they have been printed with initial caps.McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporatetraining programs. For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212)904-4069.TERMS OF USEThis is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to thework. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store andretrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative worksbased upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s priorconsent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Yourright to use the work may be terminated if you fail to comply with these terms.THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIESAS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THEWORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TOIMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and itslicensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation willbe uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, erroror omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for thecontent of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable forany indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work,even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or causewhatsoever whether such claim or cause arises in contract, tort or otherwise.DOI: 10.1036/0071494707
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C O N T E N T S
Foreword xvPreface xviiAcknowledgments xxiPART 1
THE VERDICT OF HISTORYChapter 1
Stock and Bond Returns Since 1802 3“Everybody Ought to Be Rich” 3Financial Market Returns from 1802 5The Long-Term Performance of Bonds 7The End of the Gold Standard and Price Stability 9Total Real Returns 11Interpretation of Returns 12Long-Term Returns 12Short-Term Returns and Volatility 14Real Returns on Fixed-Income Assets 14The Fall in Fixed-Income Returns 15The Equity Premium 16Worldwide Equity and Bond Returns: Global Stocks for the Long Run 18Conclusion: Stocks for the Long Run 20Appendix 1: Stocks from 1802 to 1870 21Appendix 2: Arithmetic and Geometric Returns 22
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Chapter 2
Risk, Return, and Portfolio Allocation:Why Stocks Are Less Risky Than Bonds in the Long Run 23Measuring Risk and Return 23Risk and Holding Period 24Investor Returns from Market Peaks 27Standard Measures of Risk 28Varying Correlation between Stock and Bond Returns 30Efficient Frontiers 32Recommended Portfolio Allocations 34Inflation-Indexed Bonds 35Conclusion 36Chapter 3
Stock Indexes: Proxies for the Market 37Market Averages 37The Dow Jones Averages 38Computation of the Dow Index 39Long-Term Trends in the Dow Jones 40Beware the Use of Trend Lines to Predict Future Returns 41Value-Weighted Indexes 42Standard & Poor’s Index 42Nasdaq Index 43Other Stock Indexes: The Center for Research in Security Prices (CRSP) 45Return Biases in Stock Indexes 46Appendix: What Happened to the Original 12 Dow Industrials? 47Chapter 4
The S&P 500 Index: A Half Century of U.S. Corporate History 51Sector Rotation in the S&P 500 Index 52Top-Performing Firms 58How Bad News for the Firm Becomes Good News for Investors 60Top-Performing Survivor Firms 61Other Firms That Turned Golden 62Outperformance of Original S&P 500 Firms 63Conclusion 64
CONTENTS
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Chapter 5
The Impact of Taxes on Stock and Bond Returns:Stocks Have the Edge 65Historical Taxes on Income and Capital Gains 66A Total After-Tax Returns Index 66The Benefits of Deferring Capital Gains Taxes 69Inflation and the Capital Gains Tax 70Increasingly Favorable Tax Factors for Equities 72Stocks or Bonds in Tax-Deferred Accounts? 73Conclusion 74Appendix: History of the Tax Code 74Chapter 6
The Investment View of Stocks:How Fickle Markets Overwhelm Historical Facts 77Early Views of Stock Investing 79The Influence of Smith’s Work 80Common Stock Theory of Investment 82A Radical Shift in Sentiment 82The Postcrash View of Stock Returns 83The Beginning of the Great Bull Market 85Warnings of Overspeculation 86The Top of the Bubble 88The Bear Market and Its Aftermath 89
PART 2
VALUATION, STYLE INVESTING, AND GLOBAL MARKETSChapter 7
Stocks: Sources and Measures of Market Value 95An Evil Omen Returns 95Valuation of Cash Flows from Stocks 97Sources of Shareholder Value 98The Value of Stock as Related to Dividend Policy 100
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Earnings Concepts 102Earnings Reporting Methods 102The Employee Stock Option Controversy 104Controversies in Accounting for Pension Costs 105Standard & Poor’s Core Earnings 107Earnings Quality 108Downward Biases in Earnings 109Historical Yardsticks for Valuing the Market 110Price-Earnings Ratios 110The Fed Model, Earnings Yields, and Bond Yields 113Corporate Profits and National Income 115Book Value, Market Value, and Tobin’s Q 117Market Value Relative to the GDP and Other Ratios 119Conclusion 121Chapter 8
The Impact of Economic Growth onMarket Valuation and the Coming Age Wave 123GDP Growth and Stock Returns 124The Gordon Dividend Growth Model 126Economic Growth and Stock Returns 127Factors That Raise Valuation Ratios 128Factors That Impact Expected Returns 129The Equity Risk Premium 130More Stable Economy 131New Justified P-E Ratios 132The Age Wage 133Demography Is Destiny 134The Bankruptcy of Government and Private Pension Systems 135Reversal of a Century-Long Trend 135The Global Solution: An Opportunity to Make a Trade 136Attraction of U.S. Capital 137Conclusion 138
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Chapter 9
Outperforming the Market: The Importance ofSize, Dividend Yields, and Price-to-Earnings Ratios 139Stocks That Outperform the Market 139Small- and Large-Cap Stocks 141Trends in Small-Cap Stock Returns 142Valuation 144Value Stocks Offer Higher Returns Than Growth Stocks 144Dividend Yields 145Other Dividend Yield Strategies 147Price-to-Earnings (P-E) Ratios 149Price-to-Book Ratios 150Combining Size and Valuation Criteria 152Initial Public Offerings: The Disappointing OverallReturns on New Small-Cap Growth Companies 154The Nature of Growth and Value Stocks 157Explanations of Size and Valuation Effects 157The Noisy Market Hypothesis 158Conclusion 159Chapter 10
Global Investing and the Rise of China, India,and the Emerging Markets 161The World’s Population, Production, and Equity Capital 162Cycles in Foreign Markets 164The Japanese Market Bubble 165The Emerging Market Bubble 166The New Millennium and the Technology Bubble 167Diversification in World Markets 168Principles of Diversification 168“Efficient” Portfolios: Formal Analysis 168Should You Hedge Foreign Exchange Risk? 173Sector Diversification 173Private and Public Capital 177
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The World in 2050 178Conclusion 182Appendix: The Largest Non-U.S.-Based Companies 182
PART 3
HOW THE ECONOMIC ENVIRONMENT IMPACTS STOCKSChapter 11
Gold, Monetary Policy, and Inflation 187Money and Prices 189The Gold Standard 191The Establishment of the Federal Reserve 191The Fall of the Gold Standard 192Postdevaluation Monetary Policy 193Postgold Monetary Policy 194The Federal Reserve and Money Creation 195How the Fed’s Actions Affect Interest Rates 196Stocks as Hedges against Inflation 199Why Stocks Fail as a Short-Term Inflation Hedge 201Higher Interest Rates 201Nonneutral Inflation: Supply-Side Effects 202Taxes on Corporate Earnings 202Inflationary Biases in Interest Costs 203Capital Gains Taxes 204Conclusion 205Chapter 12
Stocks and the Business Cycle 207Who Calls the Business Cycle? 208Stock Returns around Business Cycle Turning Points 211Gains through Timing the Business Cycle 214How Hard Is It to Predict the Business Cycle? 216Conclusion 219
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Chapter 13
When World Events Impact Financial Markets 221What Moves the Market? 223Uncertainty and the Market 226Democrats and Republicans 227Stocks and War 231The World Wars 231Post-1945 Conflicts 233Conclusion 235Chapter 14
Stocks, Bonds, and the Flow of Economic Data 237Economic Data and the Market 238Principles of Market Reaction 238Information Content of Data Releases 239Economic Growth and Stock Prices 240The Employment Report 241The Cycle of Announcements 243Inflation Reports 244Core Inflation 245Employment Costs 246Impact on Financial Markets 246Central Bank Policy 247Conclusion 247
PART 4
STOCK FLUCTUATIONS IN THE SHORT RUNChapter 15
The Rise of Exchange-Traded Funds,Stock Index Futures, and Options 251Exchange-Traded Funds 252Stock Index Futures 253Basics of the Futures Markets 255
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Index Arbitrage 257Predicting the New York Open with Globex Trading 258Double and Triple Witching 260Margin and Leverage 261Using ETFs or Futures 261Where to Put Your Indexed Investments:ETFs, Futures, or Index Mutual Funds? 262Index Options 264Buying Index Options 266Selling Index Options 267The Importance of Indexed Products 267Chapter 16
Market Volatility 269The Stock Market Crash of October 1987 271The Causes of the October 1987 Crash 273Exchange-Rate Policies 274The Futures Market 275Circuit Breakers 276The Nature of Market Volatility 277Historical Trends of Stock Volatility 278The Volatility Index (VIX) 281Recent Low Volatility 283The Distribution of Large Daily Changes 283The Economics of Market Volatility 285The Significance of Market Volatility 286Chapter 17
Technical Analysis and Investing with the Trend 289The Nature of Technical Analysis 289Charles Dow, Technical Analyst 290The Randomness of Stock Prices 291Simulations of Random Stock Prices 292Trending Markets and Price Reversals 294Moving Averages 295Testing the Dow Jones Moving-Average Strategy 296Back-Testing the 200-Day Moving Average 297The Nasdaq Moving-Average Strategy 300
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Distribution of Gains and Losses 301Momentum Investing 302Conclusion 303Chapter 18
Calendar Anomalies 305Seasonal Anomalies 306The January Effect 306Causes of the January Effect 309The January Effect Weakened in Recent Years 310Large Monthly Returns 311The September Effect 311Other Seasonal Returns 315Day-of-the-Week Effects 316What’s an Investor to Do? 318Chapter 19
Behavioral Finance and the Psychology of Investing 319The Technology Bubble, 1999 to 2001 320Behavioral Finance 322Fads, Social Dynamics, and Stock Bubbles 323Excessive Trading, Overconfidence, and the Representative Bias 325Prospect Theory, Loss Aversion, and Holding On to Losing Trades 328Rules for Avoiding Behavioral Traps 331Myopic Loss Aversion, Portfolio Monitoring, and the Equity Risk Premium 332Contrarian Investing and Investor Sentiment: Strategies to EnhancePortfolio Returns 333Out-of-Favor Stocks and the Dow 10 Strategy 335
PART 5
BUILDING WEALTH THROUGH STOCKSChapter 20
Fund Performance, Indexing, and Beating the Market 341The Performance of Equity Mutual Funds 342Finding Skilled Money Managers 346
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Persistence of Superior Returns 348Reasons for Underperformance of Managed Money 348A Little Learning Is a Dangerous Thing 349Profiting from Informed Trading 349How Costs Affect Returns 350The Increased Popularity of Passive Investing 351The Pitfalls of Capitalization-Weighted Indexing 351Fundamentally Weighted versus Capitalization-Weighted Indexation 353The History of Fundamentally Weighted Indexation 356Conclusion 357Chapter 21
Structuring a Portfolio for Long-Term Growth 359Practical Aspects of Investing 360Guides to Successful Investing 360Implementing the Plan and the Role of an Investment Advisor 363Concluding Comment 364
Index 367
CONTENTS
F O R E W O R D
Some people find the process of assembling data to be a deadly bore.Others view it as a challenge. Jeremy Siegel has turned it into an artform. You can only admire the scope, lucidity, and sheer delight withwhich Professor Siegel serves up the evidence to support his case for investing in stocks for the long run.But this book is far more than its title suggests. You will learn a lotof economic theory along the way, garnished with a fascinating historyof both the capital markets and the U.S. economy. By using history tomaximum effect, Professor Siegel gives the numbers a life and meaningthey would never enjoy in a less compelling setting. Moreover, he boldlydoes battle with all historical episodes that could contradict his thesisand emerges victorious—and this includes the crazy years of the 1990s.With this fourth edition, Jeremy Siegel has continued on his merryand remarkable way in producing works of great value about how best toinvest in the stock market. His additions on behavioral finance, globalization, and exchange-traded funds have enriched the original materialwith fresh insights into important issues. Revisions throughout the bookhave added valuable factual material and powerful new arguments tomake his case for stocks for the long run. Whether you are a beginner atinvesting or an old pro, you will learn a lot from reading this book.Jeremy Siegel is never shy, and his arguments in this new editiondemonstrate he is as bold as ever. The most interesting feature of thewhole book is his twin conclusions of good news and bad news. First,today’s globalized world warrants higher average price-earnings ratiosthan in the past. But higher P-Es are a mixed blessing, for they wouldmean average returns in the future are going to be lower than they werein the past.I am not going to take issue with the forecast embodied in this viewpoint. But similar cases could have been made in other environments ofthe past, tragic environments as well as happy ones. One of the great lessons of history proclaims that no economic environment survives thelong run. We have no sense at all of what kinds of problems or victorieslie in the distant future, say, 20 years or more from now, and what influence those forces will have on appropriate price-earnings ratios.That’s all right. Professor Siegel’s most important observationabout the future goes beyond his controversial forecast of higher averxvCopyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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age P-Es and lower realized returns. “Although these returns may be diminished from the past,” he writes, “there is overwhelming reason to believe stocks will remain the best investment for all those seeking steady,long-term gains.”“[O]verwhelming reason” is an understatement. The risk premium earned by equities over the long run must remain intact if the system is going to survive. In the capitalist system, bonds cannot andshould not outperform equities over the long run. Bonds are contractsenforceable in courts of law. Equities promise their owners nothing—stocks are risky investments, involving a high degree of faith in the future. Thus, equities are not inherently “better” than bonds, but wedemand a higher return from equities to compensate for their greaterrisk. If the long-run expected return on bonds were to be higher thanthe long-run expected return on stocks, assets would be priced so thatrisk would earn no reward. That is an unsustainable condition. Stocksmust remain “the best investment for all those seeking steady, longterm gains” or our system will come to an end, and with a bang, not awhimper.Peter Bernstein
P R E F A C E
I wrote the first edition of Stocks for the Long Run with two goals in mind:to document the returns on the major classes of financial assets over thepast two centuries and to offer strategies that maximize long-term portfolio growth. My research definitively showed that over long periods oftime, the returns on equities not only surpassed those on all other financial assets but were far safer and more predictable than bond returnswhen inflation was taken into account. I concluded that stocks wereclearly the asset of choice for investors seeking long-term growth.I am both honored and flattered by the tremendous reception thatthe core ideas of Stocks for the Long Run have received. Since the publication of the first edition 13 years ago, I have given hundreds of lectures onthe markets and the economy both in the United States and abroad. Ihave listened closely to the questions that audiences pose, and I havecontemplated the many letters, phone calls, and e-mails from readers.My responses have formed the basis of much of the new material thathas been added to the fourth edition of Stocks for the Long Run.
NEW MATERIAL IN THE FOURTH EDITIONThe fourth edition not only updates all the data from the third edition,but it also introduces completely new material on such topics as whichstocks have done well in the long run and what will be the distributionof world output and equity values in the middle of this century. A wholenew chapter has been added on the history of the firms in the S&P 500Index, which celebrated its fiftieth anniversary in March 2007.A recurring theme in this edition of Stocks for the Long Run is that“growth does not imply return.” This principle can be applied to individual stocks, industries, and even countries. I show the superiority ofhigh-dividend-yield and low-P-E strategies for the stocks in the S&P 500Index. Sector growth turns out to play only a minor role in determiningreturns. These findings support the conclusion that value stocks outperform growth stocks in the long run, a phenomenon that has been welldocumented in the finance literature.In the preface to the 2002 edition of Stocks for the Long Run, I wrote,“Although I still believe that [capitalization-weighted] indexed investments should constitute the core of every investor’s long-term portfolio,xviiCopyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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. . . [s]ome indexes, such as the Standard & Poor’s (S&P) 500 Stock Index,have become so popular that entry to the index carries with it a pricepremium that may reduce future returns.”Further research has supported this contention. The chapter on thehistory of the S&P 500 Index shows that the new firms added to theindex have generally had lower returns than the original firms that werechosen in 1957. In this edition, I introduce the “noisy market hypothesis,” an alternative to the efficient market hypothesis that explains whyvalue stocks outperform growth stocks. In Chapter 20, I describe “fundamentally weighted” indexes as an efficient alternative to capitalization-weighted indexes for capturing the value premium.Any analysis of the stock market today must be international inscope, and in this edition I have greatly expanded the material on international markets. I detail the role of the developing economies in mitigating the aging crisis that will soon envelop the United States, Europe,and Japan as the ranks of retirees swell. I believe that Asia and other developing countries will, by the middle of this century, play a dominantrole in the world’s economy and capital markets. I conclude that Americans face a crucial choice—allow the influx of foreign capital or face poorfinancial returns and a far more difficult retirement period.All this makes investing in international equities not only important but critical to developing a comprehensive investment strategy. Thechapter on global economics shows that despite the increased shortterm correlation between country returns, global diversification is stillan essential part of today’s investment strategy. Without doubt, the portion of the world’s equity capital that is located outside the United Stateswill grow rapidly in the coming years.The fourth edition also reevaluates the findings reported in the previous editions. Such topics as calendar anomalies (for example, the January Effect), the impact of Fed interest rate changes on the stock market,and the importance of investor sentiment in predicting future market returns are given a new look. I determine whether there have been anysystematic changes in the response to these factors since the first editionof Stocks for the Long Run was published in 1994.There are some surprising results: some of the calendar anomalieshold up very well while others disappear altogether. For example, Fedrate cuts, although having a powerful immediate impact on stock prices,do not have as predictable an intermediate-term impact as they oncehad. Other topics examined include the “Gordon model” of stock valuation and economic growth, the increasing advantage of exchange-tradedfunds over mutual funds, momentum investing, and why many “bears”
PREFACE
PREFACE
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have misinterpreted historical evidence on dividend growth and corporate profits.
CONCLUDING REMARKSSince the publication of the first edition of Stocks for the Long Run, therehave been some extraordinary events in the capital markets. The greatest bull market in the 200-year history of U.S. equities ended in 2000when the surging technology stocks crashed and U.S. stocks entered asevere bear market. And the terrorist attacks of 9/11 closed the exchangefor four days, the longest period since the Great Depression.Yet the public, once regarded as fickle and quick to abandon stocksin difficult times, stuck with equities. There appeared to be much lesspublic disenchantment with stocks in the last bear market than in previous downturns, and surveys showed that most retained their faith thatstocks were still the best long-term investment. If earlier editions ofStocks for the Long Run played some small part in stock investors’ newfound tenacity, I take great satisfaction.Nevertheless, all who strive to be successful investors must exercisepatience. In 1937, John Maynard Keynes stated in The General Theory:“Investment based on genuine long-term expectation is so difficulttoday as to be scarcely practicable.” Seventy years later, long-term investing is as difficult as ever, but with today’s growing global economy,there is overwhelming evidence that stocks will remain the best investment for all those seeking long-term gains.Jeremy J. Siegel
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ACKNOWLEDGMENTS
It is never possible to list all the individuals and organizations that havepraised Stocks for the Long Run and encouraged me to update and expand past editions. Many who provided me with data for the first threeeditions of Stocks for the Long Run willingly contributed their data againfor this fourth edition, including the Vanguard Group, Morgan Stanley,Smithers & Co., and Randell Moore of Blue Chip Economic Indicators.Jeremy Schwartz, who was my principal researcher for the thirdedition of Stocks for the Long Run as well as for The Future for Investors,provided invaluable assistance for the fourth edition. More than a yearago he and I sketched the outline for the new edition, and his participation, despite the heavy demands of his own new career, was essential tothis edition’s success. As with previous editions, this work would nothave been possible without the help of Wharton students. In particular,I wish to thank Winston Liu, Peter Yi Wang, Anthony Massaro, andAdam Freedman for their invaluable help. Adam Freedman especiallyprovided critical research support during the final stages of this manuscript, and without his dedicated work, this edition would not havebeen completed in a timely manner.A special thanks goes to the thousands of financial advisors fromdozens of financial firms, such as Merrill Lynch and Morgan Stanley,who have provided me with invaluable feedback on earlier editions ofStocks for the Long Run in seminars and open forums. As senior investment strategy advisor to WisdomTree Investments, I have been betterable to articulate the value-based strategies discussed in this book.Again, I am honored that Peter Bernstein has written a foreword forthis fourth edition. I strive to attain the clarity that he has achieved in hisbestselling books about the history and practice of investing.For a manuscript to become a finished book requires an editor, andI can honestly say that Leah Spiro of McGraw-Hill took over the responsibility from Jeffrey Krames, my editor for the last two editions, withboth skill and enthusiasm. Her input helped focus the material, and herencouragement spurred me to meet the tight deadlines. As with the lastedition, Jane Palmieri did a superb job as editing manager.As before, the support of my family was critical in my being able toproduce this edition. Now that my sons are grown and out of the house,it was my wife Ellen who had to pay the whole price of the long hoursxxiCopyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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spent producing this book. She convinced me to completely clear mysummer schedule so that I could complete the first draft before theschool year—and my extensive lecturing schedule—began. That superbadvice enabled us to take a weeklong vacation in Scotland before beginning the demanding job of editing the final drafts of the book. I am hopeful that my efforts will bring us even more time together in the future.
STOCKS FOR THELONG RUN
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1
PA R T
THE VERDICT OF HISTORY
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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1
CHAPTER
STOCK AND BONDRETURNS SINCE 1802I know of no way of judging the future but by the past.PA T R I C K H E N R Y, 1 7 7 5 1
“EVERYBO