STOCKS VS. BONDS: EQUITIES HAVE A SMALLER EDGE
History shows that over the long term, stocks have far outperformed bonds. From 1927 to 1993, the difference between investors' return on stocks and the return on bonds--the so-called equity premium--was about seven percentage points.
In the past couple of years, however, the equity premium has hovered between two and three percentage points. That being the case, should stock market investors, many of them new to the game, expect the equity premium to return to its historical level?
Perhaps not, concludes Olivier J. Blanchard, an economist at the Massachusetts Institute of Technology. In the latest Brookings Papers on Economic Activity, Blanchard finds a long-term decline in the equity premium since that difference reached more than 10% in the late 1940s.
Blanchard believes that premiums surged following the 1929 stock market crash and the Great Depression as investors pulled their money out of stocks. Then, the equity premium slowly eroded as memories of that market catastrophe faded and buying picked up. Moreover, the post-World War II period witnessed the rise of long-term investors, such as pension funds, and these investment pools put more and more money into stocks. In 1950, the share of equities held by pension funds (state, local, and private) was a mere 1%; by 1970, it had reached 9%, and these days, it's 29%.
But it's important to remember that the trend toward thinner equity premiums has been masked by significant swings in inflation over the past two decades. When inflation picked up in the late 1970s, for example, the real return to bonds was hammered, and the equity premium widened. Then, when inflation slowed in the 1980s, real bond returns increased sharply, and the equity premium narrowed. So as long as inflation stays at its current low level, investors should expect equities to outperform bonds by a far narrower margin than the historical average would suggest.EDITED BY MICHAEL J. MANDEL Christopher Farrell in New York