Motley Fool Hidden Gems Investing - Stocks for the Long Run

Episode Date: February 4, 2023

If you want to know how the market could perform in the future, then look back a couple hundred years. Jeremy Schwartz is the Global Chief Investment Officer at WisdomTree and co-host of the “Behind the Markets” podcast. He’s also co-author of the latest edition of the best-selling book, “Stocks for the Long Run.” Robert Brokamp caught up with Schwartz to discuss: - Why “dying industrial companies” have beaten the broader market - Managing cash in a higher interest rate climate - How often investors should rebalance - The data that the Federal Reserve may be misreading Companies and investments discussed: MSFT, CVS, KO, DTH, AMZN, XOM, CVX, USFR Host: Robert Brokamp Guest: Jeremy Schwartz Producer: Ricky Mulvey Engineers: Annie Franks, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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since the Great Depression. That is not a positive sign for the economy. The record yield curve inversion is not a good sign for the economy. They're looking at wrong data. They should have been looking at what's happening in the housing market and said we had double digit inflation in 2021 when they were saying inflation was transitory. Now it's going down, not just declining as a rate, actual prices declining. I'm Chris Hill, and that's Jeremy Schwartz. He's the Global Chief Investment Officer at WisdomTree and co-host of the Behind the Markets podcast. On top of that, he's the co-author with Jeremy Siegel of the latest edition of the bestselling book, Stocks for the Long Run, which just happens to be Robert Brokamp's favorite book

on investing. So, Bro caught up with Jeremy Schwartz to talk about how market data from more than 100 years ago has insights for investors today, the case for international stocks, and handling cash as interest rates rise. One quick note, this conversation was recorded before the Federal Reserve's meeting on Wednesday. Let's start with just the fundamental premise of the book. The reason I love the book so much is the breadth really of the topics. It's a history book, an investing guide, an economics primer. It goes through the major booms and busts over the last 100 or so years, even touches on one of my favorite topics, safe withdrawal rates and retirement. But the foundation of the book, as you might guess with a name like Stocks for the

Long Run, is that the stock market is the place to be. The book has data going back to 1802 and shows that stocks have returned anywhere between 6.6% and 7.1% after inflation over multiple longer term holding periods. And the consistency is actually rather remarkable. So what explains that? Are there fundamentals behind that? Is it GDP growth, dividend growth that explain why the returns in the early 1800s are similar to the returns of the late 1900s? And why should we expect that to continue? That is a lot of great points in that opening question, Robert. I mean, there's so many points you hit on. I mean, the first step, sort of the 6.7% to 7% real after inflation return. We're in a time of high inflation, people concerned about inflation.

Stocks have been the best long-term hedge against inflation. That's one of the central conclusions from the book. Bonds, traditionally when we wrote the first edition, there was no tips bonds that actually give you that inflation kicker. So bonds have had a 35-year period with negative returns because they didn't have high enough yields to compensate for inflation. Stocks never had a 17-year period where they had a negative after inflation return. So stocks have proven to be some of the best long-term inflation hedges. Very important point. Some people have called that 6-7 type number, Siegel's constant. People referred to that because of the long periods he shows of how constant that return is. Now, and you asked the right question of like, well, why was it that

will continue to be that? And we do say, hey, returns actually probably should be lower, not as constant as that 6-7. And you say, well, what drives that 6-7? There is a fundamental relationship that we point to often, and that is the P-E ratio for the market. And I'll just make the analogy to bonds for a second. When you say, what does the TIPS yield represent? The TIPS yield is the current yield on after-inflation bonds. What does that say for future bond returns? Well, you're probably going to get close to one as sort of your 10-year bond return. The yields and the tips are just slightly above one today. And people get that the higher the price goes, the lower the yield on bonds. And that's a good start. The starting yield is a very great indicator of what

your next 10-year bond return is, just sort of math there. Well, the analogy is very similar in stocks. It's the earnings yield. The earnings yield, which is the inverse of the P-E ratio, is our view tied to the forward real return. And so, you know, we do believe sort of the equilibrium more long run neutral P-E ratio is higher. If you go back the last 150 years, it's averaged 15, 15 to 16 to do medians or averages or what time period, but generally 15 to 16. Well, what's the inverse of 15? It's close to that six, seven. So if you actually get a 20, which is what we think is fair, and we talked through the factors that should justify a 20, well, that gives you a five earnings yield. And right, that could be that's your sort of

long-term return. Dividend yield is part of your earnings yield. Growth comes from the reinvestment into all that. But that earnings yield is what we think is, again, it's the after inflation real return. Earnings are, you know, the companies represent real assets. You see it with this inflation season. Companies raise their prices as they see their costs increase. That is why they're good after inflation hedges. You know, in the short run, they've fallen because of the Fed tightening cycle. But in the long run, they do provide that inflation hedge. Yeah. And just for the math of that, it's just one divided by the PE, right? So one divided by 20 gives you that 5%, and that's 5% after inflation, so a real return. But what you're thinking is

more likely what we'll get from the stock market, at least over the coming long run, so to speak. That's right. Obviously, there's parts of the market that are not 20. We could talk about where they are. But for the S&P as a whole, 20 would be a fair multiple, and maybe where people are, even with close to a 4,000 S&P, where are earnings today? Where are they going to be? right now people say 225 bottom-ups estimates, but there's talks more of 200 or below. So you're right around a 20 for this year's earnings, which gives you that sort of 5% or slightly higher if the earnings come in a little bit better than expected. Well, so the book provides a lot of fascinating history about the stock market, including things like what happened to the

original 12 stocks that were in the Dow when it was launched in 1896, which was really mostly commodity-like industrials. Companies like American Sugar, Chicago Gas, National Lead, U.S. Leather, these companies like that. The book also goes into the history of the S&P 500, which was launched in 1957. For the first 30 years, it was restricted to a certain portfolio formula. 425 industrials, 25 railroads, 50 utilities. It's all very interesting, but it might make an investor wonder, how much does the historical performance of the stock market really matter when things are so different today, right? That data goes all the way back to 1802. How much do you even trust that? And is it still relevant to today's investors?

You know, so there definitely is different sources for, that's been a very common question about Siegel's 200-year data is, can you rely on the early period versus the later periods? You know, interestingly, on the early period, there was an academic who had collected that 1802 to 1870. That's one of the reasons why we break out the different clusters. The 1871 to 1925 has been well supported by the Coles Foundation out of Yale. Bob Schiller quotes a lot of that Coles Foundation data. And then through the Ibbotson period, Ibbotson collected data out of the University of Chicago, and that got acquired by Morningstar. But it's been well known through the last hundred years from Ibbotson, the Coles, 1871, 1925.

And then this Schwert data is what was going on for the first 70 years. What's interesting is there was basically no price appreciation back in that first 70 years. It was all dividend returns. So stocks were basically very much like bonds in many ways that you didn't get much of the return from that. The real return basically just came from, there was no inflation back then either, by the way, but it was essentially all the return was coming from dividends.

So it was much easier even to measure the returns for that. Yes, the economies have changed. Yes, the returns have changed. firms are not doing anywhere near as much dividends in the U.S. today as they used to from the nature of just how things have evolved the last four years. We're doing a lot more buybacks is one of those things. Things are always changing. But what's interesting, Robert, about that question, one of the things we show, and this was from the Future for Investors, and we update some of that here, not all of the work that took me three or four years to complete

the study for this when I was one of the students at Wharton. But if you were to track the original stocks from 1957. And by the way, if you bought these stocks in 1957, it was over 20% energy, 20% materials. You had nothing in technology, nothing in healthcare, almost nothing in banks, which, you know, when we first did this in 05, it was over half the portfolio. And you had all these quote unquote dying sectors that were now less than 5%. You had half your portfolio was It's gone down to 5% of the S&P 500. The question we asked was, how much did you lag the S&P by, right? There was a book, Creative Destruction, essentially, I think it was two McKinsey people who wrote

it saying how, you know, how the new is very critical to your returns. You know what the answer was? How much did you lag the market? You beat the market by about a percent. And we had tracked the original history through all their spinoffs, mergers. You bought and held. You never sold. You never added the new winners, the Amazons, the Microsofts.

You never added any of those. You just bought and held the original quote-unquote dying companies. And what it came was in nine of the 10 sectors, the original companies outperformed the actual sectors. And what was interesting about that was, you know, basically, you know, S&P would never add a new sector. Then you have this energy boom. They added all these companies in the 80s. There was no new telecom companies until the late 90s. They added all these telecom companies.

and you would buy things after they've run up in price and sort of forward-looking returns are lower. And so that was part of the sort of growth trap idea. So I think the short answer is you don't always need the new and upcoming. The old can actually represent good values. And now value didn't work for the last 15 years. That's a whole nother topic. But we do believe the data is there. We do believe there's fundamental relationships of why the markets delivered their returns, coming back to that PE ratios. You just got to be sensitive to that as you construct your portfolios. Yeah. One of the interesting stories, one of my favorite stories, when you look at the original companies in the S&P 500 was

Melville Shoe. So Melville Shoe has outperformed since 1957. And people are like, I've never heard of Melville Shoe. But that's because in 1969, it purchased a small personal health company called Consumer Value Stores, which eventually that grew much faster than the shoe company. So it became CVS, which of course is now the biggest pharmaceutical retailer. And it's a great example of how things change over the years and how if you have a good company that somehow manages to adapt, it can still be a great investment. Absolutely. So the past gives a strong hint about what the future could be. It's called stocks for the long run. But what is the long run, right? So if I'm an investor today and say, okay, I got to portion

my portfolio between cash, bonds, and stocks, what's the timeframe that I need to feel comfortable that stocks are the place to be? Well, it depends how comfortable you want to be. So the longer the time horizon, the more often stocks beat bonds. And this is one of the tables we show early on in the book is if you look at one-year periods, two-year periods, five-year, 10-year, 20, 30 years, over the over 30 year periods you know if you look in the last 150 years it was like 99 percent of the time stocks beat bonds the the shorter the horizon the more times you might have been better in cash or bonds 20 years is 95 percent of the time you go down to 10 years it's 80 percent of the time essentially stock beats bonds five years it's down to 70 percent of the time two years it's

two-thirds of the time you know one year it's about 62 percent time so the again the longer your horizon, the more confident you are. Again, 17 years was the longest period. Stocks had a negative real return. Bonds' longest negative was 35 years. But again, coming back to the forward-looking real returns from today, bond tips yields are one. We're talking about one of our major themes at WisdomTree is, hey, there's income back in fixed income. High-yield bonds, you can get close to eight. The treasury nominals, you're getting three and a half. But that's still before inflation. You know, in stocks, we think are more like 5% after inflation.

So it's really five versus one is your tradeoff today on sort of a long term 10 year. Let's say you just took 10 year horizons, 10 year tips, one little bit over one versus five. We think, you know, you're going to be very heavily the next 10 years. You're going to be better off being stocks. And in fact, the equity premium is higher than the Siegel 200 year data, even though you might say stocks are expensive. bonds are more expensive. So, you know, the main alternative stocks is bonds. You've talked about bonds a little bit. And one of the main lessons of the book is really that people think, well, bonds are safer than stocks, but actually that's not

true. And you've touched on that a big part already in that you can't just worry about what happens from year to year. You have to worry about making sure that your portfolio keeps up with inflation because that's the whole reason you're investing. You want to buy something in the future and you have to make sure that it's growing enough to be able to pay at those future higher prices. Obviously, though, as you point out, maybe not all your money should be in the stock market. When you look at the bond market, last year, it was down 13%, worst year for bonds in our lifetime. Maybe talk a little bit about what Wisden Free does in terms of bond investing and bond ETFs and how they balance these, I think, almost awakened risks to the bond

market that people didn't think existed. Well, fascinatingly, our largest ETF today is actually a floating rate treasury product. It's now, we raised over $10 billion last year in USFR. It's our floating rate treasury ETF. And the reason why, it's got one week duration. So it's basically the shortest duration treasury bonds you can buy in the market. So what is the yield on that today?

It's in the high force. I mean, 460 to 470, it's like the, practically one of the highest yielding treasury securities because of the inverted yield curve. You actually have record yield curve inversion going back the last 40 years. Because of how tight the Fed is, we're going to have, again, the Fed meeting this week. We'll see what they do, how hawkish they're going to stay. The longer they stay hawkish and high, the more you want to stick with USFR in the short run.

You know, we do like high yield bonds over the longer run. I mean, that's definitely more of a Siegel position is, you know, the hybrid between stocks and bonds. He's always talked about high yield. Now, with high yield, do you just want to give the most weight to those companies that have the most bonds debt outstanding? We try to filter for fundamentals and quality. We screen for free cash flow. Can these companies pay back their debt, not just as their yield? So it's sort of like a quality screen on high yield.

WFHY is our high yield bond ETF. We have some core strategies as well. But I think USFR for treasuries and high yield are the two we're talking about the most right now. And one is just for how are you managing your short duration cash? You know, the bank accounts, checking accounts, you're not, you didn't have to think about cash when rates were zero, but now you got to really start thinking about what am I getting in my savings accounts, my CDs, when you can buy an ETF, get rid of it the next day and be, you know, with the Fed, some of the highest yielding treasuries around.

That's definitely been a compelling ETF, but then also if you're willing to take more risk going out to that high yield with a quality screen is also very, very useful. Yeah. I don't know if they say this anymore, but back in my financial advisor days, we would say about high yield, it had 80% of the returns of the stock market with only about 50% of the volatility. So it's still not the same as buying treasuries, but you get a decent risk return, risk adjusted return from high yield. I mean, if you're getting eight, right? Like if you're getting eight and I'm saying your long-term stock return is five plus inflation, is, you know, you're talking seven to eight, right? So you're getting close to that with

where are stocks priced. Now the question is, are you going to have defaults in these high yield bonds? You know, and we do think we have a way to mitigate that. And so, yeah, there's a lot of research on our site about these fundamental screens, but that's a great point, Robert, there on the risk return trade-offs there. In the book, you have some of the data on the long-term outperformance of value, the long-term outperformance of dividend payers. And you talk a lot about how things sort of changed around the 1980s when companies did more share buybacks than dividends. So maybe talk a little bit about, are they the same? Is a share buyback a more tax-efficient dividend? In short, yes. You have a few different

ways of returning capital. It could be dividends, it could be buybacks, you could retain earnings. And in theory, buybacks should work very much like dividends, but they do have that tax preference. You say, why did firms start doing buybacks? A lot of it comes back to tax laws and how we compensated executives. If you pay your executives in options, what happens when you pay a dividend? The stock goes down by the amount of the dividend. Your options become worth less.

So the day Microsoft paid their first dividend, they canceled their stock option policy and started doing restricted stock. That's one of the stories we talk about when when Microsoft paid its first dividend in 2003, I want to say, you know, and so that it very much connected to executive compensation. We do the most stock options. That's why we do the most buybacks. I mean, that's very much a one for one. And then there's other tax reasons. You don't you can choose when you pay your capital gain versus, hey, everybody's tax when you get the dividend. And there is still a big investing group that likes dividends and prefers dividends. Buybacks are definitely much more noisier, more unpredictable. And there's still a lot of the option dilution that's coming where firms are issuing shares.

And so you're not having net share count reduction. You'd like to see it lead to share count reduction. We actually did create a strategy that does dividends plus buybacks. And you can get 8% to 9% buyback. There is a group of stocks that think their stocks are really cheap, buying back a lot of their shares. But there is the demographic profile of the aging of the population that's looking for more income. And there is something about the behavioral tendency that people don't like to sell shares, even though you could create income by selling shares or creating cash flow by

selling shares versus getting the income just off of the portfolio without having to sell shares. There is a preference for income in many people's portfolios. But in theory, yes, they're very similar. We've even gone after buybacks in a smaller way than we've gone after dividends with one single option versus the whole family, but we do believe that both are good measures of value. Talking a little bit more about what you do at WisdomTree and the book, and the book comes down on the side of indexing for sure, but also discusses some of the drawbacks of the way many of the biggest indexes are constructed. WisdomTree specializes in what's called fundamentally weighted indexing. For those who aren't familiar with it, explain what it is

and how it's different and, you know, maybe even better than indexes weighted according to market cap. So a few different things. I mean, one of the things that really appealed to Siegel on the value style through fundamentally weighted indexes, particularly the ones that WisdomTree did, when you create a value growth cut, you're creating an arbitrary cutoff is what is value, what is growth. And I just did a piece on our website. If you search for the surprising rebalance season at S&P. How you define growth and value creates these interesting cutoffs of what is growth, what is value, and how much discounts you are versus the market. It was a very strange rebalancing season from S&P where the cheapest sector energy all of a sudden became a

growth sector and got removed from their value indexes. It's a real interesting look to go there. But part of that is because you're creating these cutoffs of what is growth and what is value. with fundamentally weighting, you essentially are going for, I'm going to own all the dividend payers, 1,300, 1,400 of them, and weight back to the total dividend stream. So going from cap weighting, which is price time shares, to dividend weighting the whole market gets you very similar to a value cut type ratio. And actually now the S&P value indexes are only one point cheaper than the S&P 500, similar in mid caps, similar in small caps, where if you do a dividend weight, you're like four points cheaper than the market in almost across the board, three to four points

cheaper, enlargement in small cap. You can get high dividend baskets that are 11 times earnings versus at 18 to 19 times earnings versus 17 for the S&P value. So right now, there's record-wide discrepancies where the high dividends are more value than even the traditional value indexes, which is sort of interesting of what's going on. But also that strange thing that happened with some of those other value indexes. But the main idea was anchoring back to total dividend streams or total earning streams, rebalancing once a year back to those versus price weighting, market cap weighting, which rides things up, rides things down, and then we'll have these arbitrary cutoffs of what's growth in value. I think one of the good points that was

made in the book about the differences between market cap and fundamentally weighted is that with a market cap index, you never sell the stock. You just write it up and you write it down, as you said, whereas a fundamentally weighted index will be like, if the price gets ahead of the fundamentals, it might cut back on that stock. And then the reverse, right? If the price falls for some other reason than fundamentals, the index, when it rebalances, will actually buy more of that. That's a perfect description. I talk about that exactly all the time, is that once a year, you're buying cheap things that are falling relative to their dividends, selling what's getting rich. And people say, well, why don't you do it more often? And it

comes back to that momentum factor. If you rebalance a fundamental index monthly, what are you doing? You're buying the losers every month. And momentum was a good strategy. You don't want to buy the losers every month. You want to have the valuation discipline correct for the longer term bubbles, longer term valuation mismatches. And you do help improve the valuation once a year, but not so that you're buying the losers every single month. And so that value is better to rebalance less often, very often than more often because of that momentum effect. Let's move on to international. The last chapter of the book is basically a guide, how you should invest, roughly speaking. One of the recommendations is that at least a third of

your equity allocation should be international stocks, which that's a tough sell these days, given what's happened over the last 10 to 15 years. What's the argument for having about a third of your stocks in international equities. And often you say you should eat your own cooking. I'll say my 401k, which is 100% wisdom tree ETFs. So I do, we have our own ETFs available in our retirement program. So I have a global allocation, 100% stocks for the long run. I've got a long horizon and I'm probably half, if not more, in foreign stocks. Now, partly it was set up global diversification. The U.S. has been rising in market cap weighted terms. I remember when we started with some

probably 50-50. Now, certainly S&P has been outperforming everything. So the cap weight indexes are approaching 60, if not more, and everybody tends to have a home country bias. But if you think about that valuation story around the world, the S&P is at 20 times. Europe you can buy international value today at nine times earnings and below. Our international high dividend is DTH, nine times earnings, 11% earnings yield. I mean, that is a very different basket than the S&P at a 5% earnings yield. And if you think that valuation matters over the long run, you know, the reason why S&P won, we had the tech champions, the tech darlings of the world for the last 15 years. Europe didn't have any of that. Well, now you say, are they cheap for a good

reason. We show a lot of research on even countries, the faster growing countries didn't often have the best returns. A lot of money chases that faster growing country, bids it up in price, and sort of slower growing countries can actually win. I think that's what could happen in Europe, international, EM, yet single digit, small single digit PEs. The US was not going to go back to a single digit PE in our view. Brazil, double digit interest rates, yes, it should have a single digit P. The S&P with 1% real bond yield is not getting to a single digit P. That's partly why I like global, but I also understand. People say the multinationals, S&P, Coca-Cola has a global business. I'm getting my foreign through Coca-Cola. I understand that, but you're paying more for

Coca-Cola than the global brands in these other markets. And so you wouldn't buy half the stock market sectors that go from A to J and ignore the other letters, why ignore half the world if that's where their market cap is and are cheaper? Let's close with a topic that is on the minds of investors as well as consumers, and that is inflation and the Fed's reaction. You and Dr. Siegel have discussed on your podcast why you think maybe the Fed is behind the curve and perhaps being way too restrictive. Explain why you think the Fed should relax at this point. In the 20 years I've known the professor, I mean, he's been passionate about that tech bubble in 2000 and rallying on that part of the market. You know, he's talked about things like in the 2009 crisis, how deeply it was a great buying opportunity.

I've never seen him so passionate about an idea that the Fed is making a major mistake. and he's well as for background for people he was trained as a monetary economist at MIT he got his PhD really he studied under Paul Samuelson other Nobel Prize winners he went to Chicago with Milton Friedman for four years for Friedman's last four years so he's very much trained in the Milton Friedman school of monetary economics more than finance he was self-taught in finance found the The Stocks for the Long Run research, interesting, is devoted the last 20 plus, 30 years on that. But he was trained as a monetary economist. So he saw the money supply explosion in 2020.

And in May of 2020, he started saying, we're going to have an inflation problem. So really before anybody, I think. And he was on the record for the last two years. You can listen to all those podcasts. Every week, he was saying, we're going to have an inflation problem. He was calling for eight hikes when nobody thought we'd hike twice last year. then they hiked 17 times. Now he's saying they should be cutting because inflation is no longer an issue. Money supply was contracting. It hasn't contracted since the Great Depression.

That is not a positive sign for the economy. The record yield curve inversion is not a good sign for the economy. They're looking at wrong data. They should have been looking at what's happening in the housing market and said we had double-digit inflation in 2021 when they were saying inflation was transitory. Now it's going down, not just declining as a rate, actual prices declining, deflation, not to 2%, prices declining. So this is a big, you know, if they use different data, they would see that. And so, you know, some of it's, hey, the trailing 12 month data versus what's been happening last six months, last three months, what's going to happen for the next 12 months, not just the last 12 months. And so there's this real time and forward looking versus

is backward looking. There's the bad housing data that's impacting some of their views. And they say they prefer this bad data versus the real time data, which is perplexing. The most perplexing is saying money supply is no relationship to inflation. That's the most frustrating part. Every time people ask Powell about the money supply, no relationship to inflation. That is just bad economics. We also don't like that he's trying to crush the workers who are trying to catch up with inflation. Hey, we created this inflationary problem and now we're not going to let you catch up to inflation. You have supply shocks. You know, a great example is, hey, we're going to grow a bunch of oranges. There's a drought and there's no oranges. What's going to happen to orange

juice prices? It's going to go up. What happens? And Powell was asked, what happened in the labor supply? There was a supply shock is what he said. Well, what happens when there's a supply shock? real prices are going to go up wage prices should go up and to not let them go up is a much more restrictive policy and a deeper recession than he needs to cause he doesn't need to cause that recession inflation will come back down and so that's a lot of key issues all wrapped in one but basic view is that he's too restrictive and should be pausing after this meeting he should be pausing this meeting they're going to hike but he should pause quickly and actually should be cutting pretty soon. Yeah. If someone wants to see an impassioned Jeremy Siegel, just look at his

when he was on CNBC talking about how the Fed is just being way too restrictive and has called really for maybe the Fed to pivot sooner than people expect. We will do that every week on Behind the Markets. You get his up-to-date commentary. We put it out in written form as well as the podcast form at wisdomtree.com. And again, the Behind the Markets podcast, you can hear them every week. That'll be continued theme until they change course. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.

Thank you.