We Never Get Tired of Talking About Stocks for the Long Run

Jeremy Schwartz is global chief investment officer at WisdomTree and co-host of the Behind the Markets podcast. He's also a co-author of the latest edition of the best-selling book Stocks for the Long Run.

Motley Fool personal finance expert 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.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on February 04, 2023.

Jeremy Schwartz: 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 decline is a rate, actual prices declining.

Chris Hill: I'm Chris Hill and that's Jeremy Schwartz. He's a 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 best-selling book, Stocks for the Long Run, which just happens to be Robert Brokamp's favorite book on investing. Brokamp 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.

Robert Brokamp: 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 economic premier. 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 percent and 7.1 percent after-inflation over multiple longer-term holding periods. The consistency is actually rather remarkable. What explains that. The fundamentals behind that is that GDP growth, dividend growth, that explain why the returns and the early 1800s are similar to the returns of the late 1900s, and why should we expect that to continue?

Jeremy Schwartz: A lot of great points that opening question, Robert. There's so many points you hit on. The first is the 6.7-7 percent real after-inflation return. We're in a time of high inflation. People are 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 and actually give you that inflation kicker. 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.

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. You asked the right question of why was it that will continue to be that. We do say, returns actually probably should be lower, not as constant as that 6-7. You say, what drives that 6-7? There is a fundamental relationship that we point too often, and that is the PE ratio for the market. I'll just make the analogy to bonds for a second. When you say what is 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 your 10-year bond return.

The yields and the tips are just slightly above one today. People get that the higher the price goes, the lower the yields on bonds, and that's a good start. The starting yield is a very great indicator of what your next 10-year bond return. It's just math there. The analogy is very similar in stocks, it's the earnings yield. The earnings yield, which is the inverse of the PE ratio is our view tied to the real return. We do believe the equilibrium more long-run neutral P ratio is higher. If you go back last 150 years, it's averaged 15-16 as your medians or averages or what time period, but generally 15-16.

What's the inverse of 15? It's close to that 6, 7. If you actually get a 20, which is what we think is fair, and we talk through the factors that should justify a 20, well, that gives you a five earnings yields. That's your longer-term return. Dividend yield is part of your earnings, yield. Growth comes from the reinvestment into all that. But that earning's yield is what we think, again, is the after-inflation real return. The companies represent real assets. You see it with this inflation season, companies raise their prices as they see their cost increase. That is why they're good after-inflation hedges. In the short run, they've fall, and this are the Fed tightening cycle. But in the long run, they do provide that inflation hedge.

Robert Brokamp: Just for the mathematics, it's just 1 divided by the PE, so 1 divided by 20 gives you that 5 and that's five percent after-inflation, so a real return. 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.

Jeremy Schwartz: That's right. Obviously, there's parts of the market that are not 20, and we can 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 at 20 for this year's earnings, which gives you that five percent or slightly higher if the earnings come in a little bit better than expected.

Robert Brokamp: Well, 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 down when it was launched in 1896. It was really mostly commodity industrials; companies like American Sugar, Chicago Gas, National Lead, US Leather, these companies like that. Book also goes in the history of S&P 500, which was launched in 1957, and 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. That data goes all the way back to 1802. How much do you even trust that? Is it still relevant to today's investors?

Jeremy Schwartz: So there definitely different sources. That's been a very common question about Siegel's 200-year data is can you rely on the early periods versus the later periods? Interestingly, on the early period, there was an academic who had collected that 1802 to 1870. That's one of the reason why we break out the different clusters. The 1871-1925 has been well supported by the Kohl's Foundation out of Yale. Bob Schiller quotes a lot of that Kohl's Foundation data. Then through the Ibbotson period, Ibbotson collected data in US, Chicago. That got acquired by Morningstar, but it's been well known for the last 100 years from Ibbotson, the Kohl's versus 1871-1925. Then this short 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. Basically, 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 US 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 [inaudible] .

But if you would attract the original stocks from 1957, and by the way, if you bought these stocks and 1957, it was over 20 percent energy, 20 percent materials. You had nothing in technology, nothing in healthcare, almost nothing in banks. When we first did the say no five, it was over half the portfolio, and you had all these dot "Dying sectors" that we're now less than five percent., yet half-year portfolio was gone down to five percent in S&P 500. The question we asked was, how much did you lag the S&P by? There was a book, creative destruction. Essentially, I think it was two McKinsey people who wrote it saying how the news 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 attract the original history through all their spin-offs, mergers, you bought and held, you never sold, you never added the new winners, the Amazons, Microsofts. You've never added any of those. You just bought and held the original, "Dying companies" and what it was in nine of the 10 sectors, the original companies outperformed the actual sectors. What was interesting about that was basically S&P would never add a new sector then you have this energy boom.

These companies in the '80s. There was no new telecom companies until the late '90s. They had all of these telecom companies. You would buy things after they've run up in price and forward-looking returns are lower. That was part of the growth trap ideas. I think the short answer is, you don't always need the new and upcoming. The olds can actually represent good values. Now, value didn't work for the last 15 years. That's a whole another topic, but we do believe the data is there. We do believe there's fundamental relationships of why the markets delivered the returns coming back to that PE ratios. You just got to be sensitive to that as you construct your portfolios.

Robert Brokamp: 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. Melville shoe has outperformed since 1957. People are like, I've never heard of Melville's 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. It became CVS, which of course is now the biggest pharmaceutical retailer. 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.

Jeremy Schwartz: Absolutely.

Robert Brokamp: 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? If I'm an investor today and say, I got a portion of my portfolio between cash, bonds, and stocks, what's the timeframe that I need to feel comfortable that stocks are the place to be?

Jeremy Schwartz: Well, it depends how comfortable you want to be. The longer the time horizon, the more often stocks beat bonds. This is one of the tables we show early on in the book. Is if you look at one-year period, two-year periods, five-year, 10-year, 20, 30 years, over 30-year periods. If you look in the last 150 years, it was like 99 percent of the time stocks beat bonds. 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're 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, one year it's about 62 percent of the time. Again, the longer horizon, the more confident you are.

Again, 17 years was the longest period stocks had a negative rate return, bond's longest negative was 35 years. But again, coming back to the forward-looking real returns from today, bond tips yields are one. One of our major themes at WisdomTree is, hey, there's income back in fixed income. High-yield bond, you can get close to eight. The treasury nominal is you're getting 3 1/2, but that's still before inflation. In stocks we think are more like five percent after inflation. It's really five versus one is your trade-off today and a long-term, 10-year. Let's say just took 10-year horizon, there's 10 year tips, a little bit over one versus five. We think the next 10 years you're going to be better off being stocks. In fact, the equity premium is higher than the Siegel's 200-year data, even though you might say stocks are expensive, bonds are more expensive.

Robert Brokamp: The main alternatives of stocks is bonds, you've talked about bonds a little bit. One of the main lessons of the book is really that people think bonds are safer than stocks, but actually that's not true. You've touched on that a big part already and 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 that maybe not all your money should be in the stock market. When you look at the bond market, last year it was down 13 percent, worst year for bonds in our lifetime. Maybe talk a little bit about what WisdomTree 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.

Jeremy Schwartz: Well, fascinatingly our largest ETF today is actually a floating rate treasury product. We raised over $10 billion last year in USFR, it's a floating-rate treasury ETF and the reason why it's got one-week duration. It's basically the shortest duration treasury bonds you can buy in the market. What is the yield on that today? It's in the high 4s. I mean, 460-470, 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. We do like high yield bonds over the longer run. I mean, that's definitely more of a Siegel position is, 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 tried to filter for fundamentals and quality. We screen for free cash flow. Can these companies pay back their debt not just as their yield? It's like a quality screen on high-yield; WFHY is our high yield bond ETF.

We have some core strategy as well, but I think USFR for treasuries and high yield are the two we're talking about the most right now. One is just for how are you managing your short duration cash; the bank accounts, checking accounts? You didn't have to think about cash when rates were zero, but now you've 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 with the Fed, some of the highest yielding treasuries around? That's definitely been a compelling ETF. Then also, if you're willing to take more risk going out to that high yield with a quality screen is also very useful.

Robert Brokamp: Yeah. I don't know if they say this anymore, but back in my financial advisor days, we would say about high-yield ahead. Eighty percent of the returns of the stock market with only about 50 percent of the volatility. It's still not the same as buying treasuries, but you get a decent risk-adjusted return from high yield.

Jeremy Schwartz: If you're getting eight and I'm saying your long-term stock return is five plus inflation is, you're talking 7-8. You're getting close to that with where are stocks price? Now the question is, are you going to have defaults in these high-yield bonds? We do think we have a way to mitigate that. Again, there's a lot of research on our site about these fundamental screens, but that's a great point Robert there and the risk return trade or so.

Robert Brokamp: In the book, you have some of the data on the long-term outperformance of value, the long-term outperformance of dividend payers, and to talk a lot about how things changed around the 1980s when companies did more share buybacks than dividends. Maybe talk a little bit about, are they the same? Is a share buyback a more tax efficient dividend?

Jeremy Schwartz: In short, yes. You have a few different ways of returning capital. It could be dividends, it could be buybacks, you could retain earnings. In theory, buybacks should work very much like dividends, but they do have that tax prep. You say, why didn't firms start doing buybacks? 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 dividends? The stock goes down by the amount of the dividend, your options become worth less. The day Microsoft paid their first dividend, they canceled their stock option policies, started doing restricted stock. That's one of the stories we talk about when Microsoft paid its first dividend in '03, I want to say.

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. Then there's other tax reasons when you pay your capital gain versus, everybody's tax when you get the dividend. There's still a big investor group that likes dividends and prefers dividends. Buybacks are definitely much more noisier and more unpredictable. 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. You actually did create a strategy that is dividends plus buybacks. You can get 89 percent buyback, you'll say.

There's a group of stocks, I think their stocks are really cheap, buying back a lot of their shares, but there is the demographic profile, e.g. the population that's looking for more income and there is something about the behavioral tenancy 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, out having to sell shares. There is a preference for income in many people's portfolio. 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 a single option versus the whole family, but we do believe they both are good measures of value.

Robert Brokamp: Talking a little bit more about what you do at WisdomTree and the book. 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 maybe even better than indexes weighted according to market cap.

Jeremy Schwartz: It's a few different things. I mean, one of the things that really appeal to Siegel on the value style through fundamentally weighted indexes, particularly the ones that recently did. When you create a value growth cut, you're creating an arbitrary cutoff is what is value, what is growth? I just did a piece on our website. If you search for the Surprising Rebalance Season at S&P, how you define growth in value creates these interesting cutoffs of what is growth, what is value, and how much discount 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 waiting, I'm going to own all the dividend payers, 1,300, 1,400 of them and wait back to the total dividend stream. Going from cap waiting, which is priced timeshares to dividend waiting. The whole market gets you very similar to a value cut type, 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 weighted you're four points cheaper than the market in almost across the board; 3-4 points cheaper in large and in small cap.

You can get high dividend baskets that are 11 times earnings versus that 18-19 times earnings versus 17 for the S&P value. Right now there's recordwide discrepancies where the high dividends are more value than even the traditional value indexes which is 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 dividends streams or total earnings streams, rebalancing once a year back to those versus price weighting, market cap weighting, which rise things up rise things down, and then we'll have these arbitrary cutoffs of what's growth in value.

Robert Brokamp: I think one of the good points that was made in the book about the difference between market cap and fundamentally weighted is that with a market cap index, you'd never sell the stock; you just write it up and you're right it down as you said. Whereas a fundamentally weighted index will do that. If the price gets ahead of the fundamentals, it might cut back on that stock and then you reverse. If the price falls for some other reason than fundamentals, the index whenever you balance will actually buy more of that.

Jeremy Schwartz: 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. People say, "Well, why don't you do it more often?" It comes back to that momentum factors. If you rebound a fundamental index monthly, what are you doing? You're buying the losers every month. 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 hope to improve the valuations once a year, but not so that you're buying the losers every single month. Value is better tree balanced, less often, very often than more often because of that momentum effect.

Robert Brokamp: 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 at least a third of your equity allocation should be international stocks. That's a tough sell these days given what's happened over the last ten to 15 years. What's the argument for having about a third of your stocks in international equities.

Jeremy Schwartz: Often you say, you should eat your own cooking. I'll say my 401(k), which is 100 percent WisdomTree ETFs. We have our own ETFs available in our retirement program. I have a global allocation, 100 percent stocks for the long run. I've got a long horizon. I'm probably half, if not more, in foreign stocks. Now, partly was set up global diversification, the US has been rising in market cap weighted terms. I remember when we started, WisdomTree was probably 50-50. Now, certainly S&P has been outperforming everything. The cap-weighted 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 percent earnings yield. That is a very different basket than the S&P at a five percent earnings yield. If you think that valuation matters over the long run, the reason why S&P, one, we're the tech champions, tech darlings of the world for the last 15 years. Europe didn't have any of that. Well, now you say that they're cheap for good reason. We show a lot of research on even the faster-growing countries and often have the best returns. A lot of money chases that faster-growing country, bids it up in price, and slower-growing countries can actually win. I think that's what could happen in Europe, international EM, yet 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 one percent real bond yields 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. You wouldn't buy half the stock market. That sector go from a to j. Ignore the other letters. Why ignore half the world? That's where their market cap is and are cheaper.

Robert Brokamp: Let's close with the 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. So explain why you think the Fed should relaxed at this point.

Jeremy Schwartz: In the 20 years I've known the professor, he's been passionate about that tech bubble in 2000 and railing on that part of the market. We've talked about things like in the 09 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. As for background for people, he was trained as a monetary economist. At MIT he got PhD. Really he studied at 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 will sell taught in finance, found if the stocks and research, interesting. He's devoted last plus 30 years on that.

But he's trained as the monetary economist. He saw the money supply explosion in 2020 and in May of 2020 started saying we're going to have an inflation problems. 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 inflation problem. He was calling for eight hikes when nobody thought we'd like twice last year, then they hike 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 carbon 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 2021 when they were saying inflation was transitory. Now it's going down. Not just decline as a rate, actual prices declining, deflation, not to two percent. Price is declining. This is big. If they use different data, they would see that. Some of it's had 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. There's this real-time and forward-looking versus backwards-looking. There's the bad housing data that's impacting some of their views.

They say they prefer this bad data versus the real-time data, which is perplexing. The most perplexing is saying money supply has no relationship to inflation. That's the most frustrating part where every time people ask about the money supply has 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. We created this inflationary problem and now we're not going to let you catch up to inflation. You have supply shocks. 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 in power zest? What happened in the labor supply. 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. To not let them go up is a much more restricted policy and a deeper recession than he needs to cause. He doesn't need to cause that recession. Inflation will come back down. That's a lot of key issues all wrapped in one but basic view is that he's too restrictive and should be pausing this meeting. They're going to hike, but he should pause quickly and actually should be cutting pretty soon.

Robert Brokamp: If someone wants to see an impassioned Jeremy Siegel, just look, it is 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.

Jeremy Schwartz: We will do that every week on behind the market to get us up to date commentary. We put it out in written format as well as the podcast form at WisdomTree.com. Again, the behind the market podcast., you can hear me every week. So that'll be continued beam until they change course.

Chris Hill: 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.