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THE DEVELOPMENT OF STOCK AND BOND
RETURNS (JANUARY 1969–DECEMBER 1981)
Because the inflation was unanticipated and allowance for
it was not incorporated into yields, investors in bonds
suffered disastrous results. In 1968, for example, thirty-year,
long-term bonds offered a yield to maturity of about 6
percent. This provided protection against the going inflation
rate of about 3 percent and an anticipated after-inflation real
rate of return of 3 percent. Unfortunately, the actual rate of
inflation over the period 1969–81 was almost 8 percent,
wiping out any positive real rate of return. That’s the good
news part of this dreary story. The bad news was that there
were capital losses. Who wanted to buy a bond yielding 6
percent in the late 1970s, when the rate of inflation was in
double digits? No one! If you had to sell your bonds, you
sold at a loss so that the new buyer could get a yield
consonant with the higher rate of inflation. Yields rose even
further as the risk premium on bonds rose to take into
account their increased volatility. To make matters worse, the
tax system delivered the unkindest blow of all to bond
investors. Even though bond investors often actually earned
negative pre-tax rates of return, their bond coupons were
taxed at regular income tax rates.
The failure of bonds to protect investors against an
unanticipated inflationary episode is hardly surprising. The
common-stock flop was something else. Because stocks
represent claims on real assets that presumably rise in value
with the price level, stock prices—according to this line of
logic—should have risen also. It’s like the story of the small
boy on his first trip to an art museum. When told that a
famous abstract painting was supposed to be a horse, the boy
asked wisely, “Well, if it is supposed to be a horse, why isn’t
it a horse?” If common stocks were supposed to be an
inflation hedge, then why weren’t they?
Many different explanations involving faltering dividends
and earnings growth have been offered that simply don’t hold
up under careful analysis. One common explanation was that
inflation had caused corporate profits to shrink drastically,
especially when reported figures were adjusted for inflation.
Inflation was portrayed as a kind of financial neutron bomb,
leaving the structure of corporate enterprise intact, but
destroying the lifeblood of profits. Many saw the engine of
capitalism as running out of control, so that a walk down
Wall Street—random or otherwise—could prove extremely
hazardous.
The facts are, however, that there was no evidence that
profits had been “sliding down a pole greased by cruel and
inexorable inflation,” as some in the financial community
believed in the early 1980s. As the preceding table shows,
profit growth accelerated over the 1969–81 period and
increased to an 8 percent rate, comfortably ahead of inflation.
Even dividends held their own, rising at close to the same rate
as inflation.
Movie buffs should recall the marvelous final scene from
Casablanca. Humphrey Bogart stands over the body of a
Luftwaffe major, a smoking gun in his hand. Claude Rains, a
captain in the French colonial police, turns his glance from
Bogart to the smoking gun to the dead major and finally to his
assistant, and says, “Major Strasser has been shot. Round up
the usual suspects.” We, too, have rounded up the usual
suspects, but we have yet to focus on who shot the stock
market.
The major reason for the poor equity returns during the
1970s was that investors’ evaluations of dividends and
earnings—the number of dollars they were willing to pay for
a dollar of dividends and earnings—fell sharply. Stocks failed
to provide investors with protection against inflation, not
because earnings and dividends failed to grow with inflation,
but rather because price-earnings multiples quite literally
collapsed over the period.
The price-earnings multiple for the S&P Index was cut by
almost two-thirds during the 1969–81 period. It was this
decline in multiples that produced such poor returns for
investors in the 1970s and that prevented stock prices from
reflecting the real underlying progress most companies made
in earnings and dividend growth. Some financial economists
concluded that the market was simply irrational during the
1970s and early 1980s—that multiples had fallen too far.
It is, of course, quite possible that stock investors became
irrationally pessimistic in the early 1980s, just as they were
possibly irrationally optimistic in the mid-1960s. But
although I do not believe the market is always perfectly
rational, if forced to choose between the stock market and the
economics profession, I’d put my money on the stock market
every time. I suspect that stock investors weren’t irrational
when they caused a sharp drop in price-dividend and price-
earnings multiples—they were just scared. In the mid-1960s,
inflation was so modest as to be almost unnoticeable, and
investors were convinced that economists had found the cure
for serious recessions—even mild downturns could be “fine-
tuned” away. No one would have imagined in the 1960s that
the economy could experience either double-digit
unemployment or double-digit inflation, let alone that both
could appear simultaneously. Clearly, we learned that
economic conditions were far less stable than had previously
been imagined. Equity securities (dare I say equity
insecurities) were, therefore, considered riskier and deserving
of higher risk compensation.
*
The market provides higher risk premiums through a drop
in prices relative to earnings and dividends; this produces
larger returns in the future consistent with the new, riskier
environment. Paradoxically, however, the same adjustments
that produced very poor returns in the late 1960s and
throughout the 1970s created some very attractive price
levels in the early 1980s, as I argued in earlier editions of this
book. The experience makes clear, however, that if one wants
to explain the generation of returns over a decade, a change in
valuation relationships plays a critical role. The growth rate
of earnings did compensate for inflation during 1969–81, but
the drop in price-dividend and price-earnings multiples,
which I believe reflected increased perceived risk, is what
killed the stock market.
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