Finance profs should stop using US data

The US is a really, really weird country:

IF THERE is an article of faith among investors, it is that equities are the best investment over the long run, far better than government bonds. But research from Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School into returns since 1900, published this week in the “Credit Suisse Global Investment Returns Yearbook”, suggests that this belief is misleading. Their data show, for example, that global bonds have delivered a better return than equities since the start of 1980. Thirty-three years is a long time by most people’s reckoning.

Add to that the problem of survivorship bias. Most investment research has focused on America, where there are a lot of finance professors. America was the great winner of the 20th century, both militarily and economically. Although its success seems obvious now, it was not the only great power a century ago nor was it the most-favoured market of early-20th-century investors.

The chart shows that in the 50 years after the end of the American civil war, the Russian stockmarket easily outperformed Wall Street. Russia, with its vast territory and industrialising workforce, was seen as the exciting growth opportunity for the 20th century. (Argentina was another favourite bullish bet.)

.  .  .

Austria has been another great historical disappointment. In the early years of the 20th century Austria-Hungary was still one of the great powers of the world, with an empire spanning much of south-eastern Europe. Defeat in two world wars, the break-up of the empire and two periods of hyperinflation meant that Austria had the worst real return of all 20 countries in the London Business School data, not just for equities but for government bonds and bills as well. An American investor who placed $1m in Austrian government bills in 1900 would now have just $100 left.

Austria shows that equities do not always pay off over the long term. Between 1900 and 2012 an investor in Austrian equities would have endured a period of 97 consecutive years of real losses. Investors in Italy and Belgium suffered real losses over periods lasting more than 70 years.

The inclusion of Russia and Austria in the database (plus China, where investors also suffered a 100% loss in 1949) is one reason why the professors show a lower historical global real annual return from equities (5% versus 5.4%) than they did in the 2012 edition of the yearbook.

.  .  .

Indeed, American investors may not realise how lucky they were. The real return from American equities between 1900 and 2012 averaged 6.3% a year; the return from the rest of the world was just 4.4%.

Lots of people have suggested that America’s amazing and unexpected economic success might explain our equity premium.  I wonder if it also explains why Robert Shiller has not done particularly well in forecasting the US stock market in recent years, despite having what I view as the best anti-EMH model (and one I’ve used successfully on occasion.)

Suppose there were periods where Americans thought we were about to become another Argentina, but then each time we stepped back from the brink.  Because these fears never panned out, the US market would appear (ex post) much too volatile.  Obviously 1932 was one such period.  But even in 1980 I can recall a sense that the dollar was becoming a joke, and America was becoming a banana republic.  Stocks were quite depressed in real terms.  As it became apparent we would avoid the worst case of currency debasement, stocks rallied sharply.  And of course the period around 9/11 and 2009 were also periods of great pessimism.

Shiller seems much better at telling people to sell than to buy.  Contrary to widespread impression his 1996 “irrational exuberance” call was not particularly accurate.  And he missed the great 2009-13 bull market in US stocks.  In my view historical P/E ratios are misleading, as the 21st century will see persistently low real interest rates on T-bonds.  That doesn’t mean I have any magic formula to predict stocks, I’m just trying to give a sense of why the market might think high stock prices are justified, whereas Shiller’s model (which does fit past data pretty well) says stocks are much too high.

Please don’t take this as a green light to go out and buy stocks—the market has just doubled, for God’s sake.  Even if I don’t agree with Shiller, it’s hard to ignore what’s happened in the past after stocks have soared.  The real purpose of this post is to argue that finance studies relying on an outlier like the US might be very misleading.  Yes, US stocks might be overvalued—but don’t rely on studies using past US data when reaching that conclusion.

PS.  I wrote this 2 weeks ago—I should have posted it right away.



35 Responses to “Finance profs should stop using US data”

  1. Gravatar of TravisV TravisV
    5. March 2013 at 14:40

    Prof. Sumner,

    If you’re impressed with the political economies of countries like Denmark, Sweden and Singapore, why not buy equities in those countries rather than U.S. equities?

  2. Gravatar of Doug M Doug M
    5. March 2013 at 15:28

    Are equities expense on a historical P/E basis? They seem to be right in line with long-term averages. Improving fundamentals has been driving the rally. Considering how expensive bonds (take your pick — US, Global, investment grade or junk) are, not bad choice to be in stocks.

  3. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    5. March 2013 at 15:36

    Even with the recent run up in stock prices, the Dow is just back to where it was in 2007.

  4. Gravatar of ssumner ssumner
    5. March 2013 at 15:38

    Travis, Most of my money is in Asia. I also have a modest amount in European and American index funds. Because of the EMH I don’t like to invest in well run countries. I like to invest in poorly run countries that I think will gradually become better run.

    Doug, Shiller said they were overpriced a few years back when the market was far lower. I can’t imagine what he thinks now.

  5. Gravatar of ssumner ssumner
    5. March 2013 at 15:38

    Patrick, And the overall market’s just back to 2000—no rise in 13 years.

  6. Gravatar of TravisV TravisV
    5. March 2013 at 15:40

    One thing that confuses me is that Warren Buffett constantly says that long-term Treasuries are an absolutely horrible investment.

    Why is Buffett so confident that the market’s valuation is wrong?

  7. Gravatar of TravisV TravisV
    5. March 2013 at 15:48

    More great stuff by Business Insider!

    The Idiot-Maker Rally: Check Out All The Gurus That Have Been Made To Look Like Fools By This Market

  8. Gravatar of Liberal Roman Liberal Roman
    5. March 2013 at 16:00

    To me it’s pretty simple why stocks are hitting new highs. We are at the same price levels as five years ago but our earnings are 40% higher. The real question is why stocks are not even higher still.

    Probably fear that fiscal and/or monetary authorities will do something stupid.

  9. Gravatar of Doug M Doug M
    5. March 2013 at 16:00

    I saw Shiller in October.

    My notes from his talk:
    Equites are not fundamentally cheap but tehy are cheap relative to bonds.
    Housing tades on momentum and not of fundametal value.
    Commodities should be in all portfolios.

  10. Gravatar of Suvy Suvy
    5. March 2013 at 16:13

    I’ve come to the opinion that we shouldn’t really worry about the equity markets for the simple reason that it is equity. The problem with debt is that it has to be paid back, equity does not. Equity is very robust and doesn’t cause much problems while debt has to be paid back and a massive increase in debt to purchase assets makes both firms and economies very sensitive to shifts in asset prices.

    About this particular equity market, I think the reason people are in equities is because they’re scared of bonds. Bonds have a negative real return right now while corporate profits have been very strong. The 10 year is at 2% and so is the dividend of the S&P. Many of these companies are very productive and healthy while US government debt is over 100% of GDP and we’re running a $1 trillion deficit. I think equities are becoming slightly overpriced, but I don’t think it’s near bubble territory.

  11. Gravatar of ant1900 ant1900
    5. March 2013 at 16:19

    Check out Eric Falkenstein’s book The Missing Risk Premium. It lays out an exhaustive empirical case on why the return from all sorts of investments – equities, horse betting, Hollywood movies, out of the money options, private equity, real estate, etc etc etc is basically zero (possibly negative) if you adjust for inflation, survivorship bias, taxes, transaction fees, and market timing (i.e., the fact that in practice investors pile in at the top and sell at the bottom).

  12. Gravatar of ant1900 ant1900
    5. March 2013 at 16:31

    Also, the Nikkei just opened up another 1%.

    Here’s a graph of various QE announcements and S&P 500 performance:

    It hasn’t been updated since September 2012, but the S&P is up 10% since then. (Source is Calculated risk:

    If the central bank is buying assets, I’m buying assets.

  13. Gravatar of Geoff Geoff
    5. March 2013 at 17:22

    The “33 years of positive data” for bonds obviously has to be understood in context, and not presumed to be able to repeat itself indefinitely.

    Bond returns can keep going up as bond prices keep going up, yes. But bond returns cannot keep going in this way forever, since at some point interest rates will hit zero.

    Speaking as a speculator only, I am 99.9999999% certain that bonds will NOT repeat the same performance they have enjoyed for the past 33 years. There is not much room for additional capital gains.

  14. Gravatar of Geoff Geoff
    5. March 2013 at 17:49

    Dr. Sumner:

    “Please don’t take this as a green light to go out and buy stocks””the market has just doubled, for God’s sake.

    Do you think that Fed policy that targets price levels, or NGDP, or interest rates, or whatever, because of how the system is set up, or because of what incentives present themselves, that monetary policy has significantly disproportionate effects on prices?

  15. Gravatar of Finance profs should stop using US data | Fifth Estate Finance profs should stop using US data | Fifth Estate
    5. March 2013 at 17:49

    […] See full story on […]

  16. Gravatar of Mike Sax Mike Sax
    5. March 2013 at 21:28

    Part of why Schiller hasn’t done so well in recent years is that there has been a lot less volatility since the market bottomed out back in March, 2009. Schiller’s whole approach is about volatility-he believes that the level of volatility in the market calls EMH into question.

    In general the market since then has been really hard to make money with any sort of aggressive trading strategies.

    Ironically, buy and hold has had a comeback-in 2008 the guys on Fast Money on CNBC were proclaiming buy and hold dead- as if you simply bought a bunch of stocks then and held on you’d bee looking pretty good right now.

  17. Gravatar of Benjamin Cole Benjamin Cole
    5. March 2013 at 21:33

    I think QE4 ($85 billion a month in QE, open-ended) is having a positive effect, on the economy and stocks.

    Just wish it was Sumner’s plan of actually getting larger every month until targets are hit. That is, next month QE would be $95 billion, and then $105 billion etc. until targets are hit and boom-times are here.

  18. Gravatar of TravisV TravisV
    5. March 2013 at 21:48

    Paul Krugman:

    “Why Don’t We Have Deflation?”

    “The bottom line is that we have a lot of evidence suggesting that the failure of deflation to materialize reflects wage rigidity, not absence of economic slack.”

  19. Gravatar of Vivian Darkbloom Vivian Darkbloom
    5. March 2013 at 23:53

    “Shiller seems much better at telling people to sell than to buy.”

    I’ve never completely understood the value of this index as a investing, much less trading tool. If you look at the past 10 years of S&P earnings, it is very easy to “predict” per that formula that stocks will magically become more attractive in the coming years even if real future earnings are stable or even decline slightly. This is because relatively low historical earnings years will be thrown out of the formula. So, why not just beat the crowd and jump the gun before the nearly inevitable occurs?

    I’m particularly looking forward to the trading opportunity toward the end of 2019 when very subpar 2009 earnings get thrown out of the formula and virtually overnight stocks become much more “valuable”.

  20. Gravatar of Mattias Mattias
    6. March 2013 at 01:56

    After WWII interest rates went up until the early 80s, and then they have went down. Of course bonds look great if you only study the last 30 years. The question is what will happen next? Will the interest rates start to rise, bonds are probably a horrible investment. If they stay low, they are a mediocre investment, but maybe better than stocks.

    Markets have developed in cycles. For the 80s and 90s both bonds and stocks were a great investment. Since 2000 bonds have continued to be a great investment, but not stocks. It would not be a great shock if the trends turned now, and we have a decade or two where stocks are doing well and bonds not.

  21. Gravatar of Mike Sax Mike Sax
    6. March 2013 at 03:51

    The trouble with bearish calls is that at some point they’re of course going to be right, howeer, if they can’t tell you when it doesn’t help much.

    1996 was too early to get out. You missed all the fun if you got out then though true if you caught it you may well have stayed on too long in 2000 and lost it all then.

    So bearish call do kind of seem like predicting that it will rain.

    IF I had to guess, I doubt we’re heading for a bear market soon-we could have a pullback of course. It will be interesting with us touching the highs of 2007 to see if we can get above that level. That would be from a technical analysis standpoint a bullish sign for stocks.

  22. Gravatar of Negation of Ideology Negation of Ideology
    6. March 2013 at 04:05

    Mike Sax –

    “So bearish call do kind of seem like predicting that it will rain.”

    Exactly! I’ve used that same analogy myself. I’m tempted to call it the “Peter Schiff strategy”, or maybe it should be named after Ron Paul. Alternate between predicting future inflations, recessions, or financial crises every day for 20 years. When something bad finally happens, put something on the internet bragging about how you were right. The important point is that you should never mention how you were wrong the other 90% of the time.

  23. Gravatar of OneEyedMan OneEyedMan
    6. March 2013 at 04:32

    Re-balancing is an essential part of passive investing. With it, it is possible to make money in situations even in China where returns in one year were -100%.

  24. Gravatar of OneEyedMan OneEyedMan
    6. March 2013 at 04:39

    At least if you are internationally diversified in addition to just splitting money between domestic fixed income and equity products.

  25. Gravatar of ssumner ssumner
    6. March 2013 at 06:04

    TravisV, Very funny link. Thanks.

    Doug, When the market was far lower Shiller said it was overpriced. I’d love to know whether he’s abandoned his model. if so, that would be a MASSIVE boon to my EMH campaign. Can anyone provide a link?

    any1900, it’s logically impossible for “investors” (as a group) to pile in at the top.

    Mike Sax, He focuses on long term volatility–which has not gone away at all.

    Vivian. Good point.

  26. Gravatar of TallDave TallDave
    6. March 2013 at 07:54

    Lots of people have suggested that America’s amazing and unexpected economic success

    Scott, have you read Acemoglu and Robinson’s “Why Nations Fail: The Origins of Power, Prosperity, and Poverty” yet? Some are saying it’s the most important economics tome of this century, and I’m increasingly inclined to agree. Not much about monetary policy, but the book is very persuasive in terms of explaining why some countries have become rich and others poor over the past couple centuries.

  27. Gravatar of Link Roundup « Belligerati Link Roundup « Belligerati
    6. March 2013 at 08:17

    […] Finance profs should stop using US data by Scott Sumner […]

  28. Gravatar of Doug M Doug M
    6. March 2013 at 10:14

    Shiller’s model is based off of P/E, using a rolling historic average for E.

    Comming out of the recession Shiller’s measure for E is growing faster than P.

  29. Gravatar of maynardGkeynes maynardGkeynes
    6. March 2013 at 15:28

    Prof S. Do you have this backwards? Isn’t the implication of the LSB study that there actually is no ERP? That in fact, stocks are riskier than they appear?

  30. Gravatar of ssumner ssumner
    7. March 2013 at 07:14

    TallDave, I haven’t read it.

    Doug, I know that, but it wouldn’t explain a dramatic turnaround–it’s a ten year average. I’d be very interested if someone could verify that he’s no longer bearish on stocks.

    Maynard, Yes, I believe that was the implication. But I don’t see how that’s inconsistent with anything in my post.

    I would add stocks “were” riskier, not “are” riskier. What are the odds of war between france and Germany in the next 25 years?

  31. Gravatar of Thursday links: sacrosanct stories – Abnormal Returns | Abnormal Returns Thursday links: sacrosanct stories - Abnormal Returns | Abnormal Returns
    7. March 2013 at 09:52

    […] How using US financial market history skews results.  (The Money Illusion) […]

  32. Gravatar of L. H. Kevil L. H. Kevil
    7. March 2013 at 10:19

    Two questions for Scott:

    Are you seriously maintaining that equities do not beat bonds in the long run? The report seems to contradict that position.

    Where in the Credit Suisse report did you get the data about global bonds beating equities since the start of 1980? I can’t find it.

  33. Gravatar of ssumner ssumner
    7. March 2013 at 13:25

    LH, In the US equities have outperformed bonds, but not in many other countries.

    I don’t understand your second question, I never discussed any Credit Suisse reports.

  34. Gravatar of L. H. Kevil L. H. Kevil
    7. March 2013 at 19:03

    Whoops – you’re right. I missed the link to the Economist article which did discuss the equities versus bonds issue. Sorry for the lack of attention.

    However, the Credit Suisse report does support the viewpoint that equities have always outperformed bonds. Here are a few statements made in it;

    P.57 reports on a 19-country (incl. US) index of world equities and another for world bonds. The data show a real return on equities of 5.4% p.a. from 1900-2011. The corresponding figure for world bonds is 1.7%. This contrasts with 6.2% real return from US equities and 2.0% for US bonds (p.56.) The volatility of the world equity index is 17.7% p.a. as against 19.9% for the US. The conclusion: “The risk reduction achieved through global diversification remains one of the last “free lunches” available to investors.”

    The report also states “In every country, local equities outperformed local government bonds and Treasury bills. Over the long term, bonds and bills have on average provided investors with low – sometimes negative – real returns.”(p.14) And again, “The real case for equities is that, over the long term, stockholders have enjoyed a large equity risk premium.” (p.15)

    The experience of these 18 countries does not support your contention that “In the US equities have outperformed bonds, but not in many other countries.”

  35. Gravatar of Brian Donohue Brian Donohue
    8. March 2013 at 15:04


    I agree with you that interest rates are gonna be low for a long time.

    All this means is that investors should be willing to tolerate a higher P/E ratio on stocks than if rates were higher.

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