Certain assumptions were made in the late 1990's that helped fuel the spectacular run up in stock prices. "It's different this time," was one of them. "Earnings can grow faster than the economy" was another. A third was that "stocks are always the best investment for the long run."

The first two assumptions were quickly and dramatically proved wrong. Stock prices plummeted beginning in 2000 as investors decided that times were not that different and they were no longer willing to accept the risk of owning high multiple stocks. Next, company profits tumbled to a much greater extent than the slowdown in the economy. The third assumption, though, has gone mostly unscathed.

Jeremy Siegel, a professor at the University of Pennsylvania, deserves some credit for the faith in stocks as long-term investments. His 1994 book Stocks for the Long Run argued that if investors were willing to hold equities for at least two decades then they were nearly guaranteed an inflation beating return. Neither bonds nor bills could offer the same promise. The real risk for long-term investors, according to Siegel, was not being invested in stocks.

After building a database of nearly 200 years of US stock and bond returns, Siegel discovered that over the past two centuries US stocks have delivered a surprisingly consistent real return (net of inflation). More importantly, he observed that stocks provided a positive, inflation-beating return in every 20-year holding period.

Considering that stocks have always outpaced inflation and bonds given enough time, he concluded: "although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true: the safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds".

Now this assumption is being questioned. In this month's Financial Analysts Journal, three researchers at the London Business School say that investors can no longer rely on a twenty-year positive real return from stocks 1 . They say that equities have a good shot at delivering negative annualized real returns over the next two decades.

The researchers - Elroy Dimson, Paul Marsh, and Mike Staunton - have recently completed their own data-gathering endurance event. They collected over 100 years of security returns in 16 countries. (The full data set is discussed in their 2002 book, Triumph of the Optimists.)

This collection of country data gave them a much broader context in which to examine the historical returns in the U.S.. The impressive streak of 20-year positive real returns can be explained two ways, say the authors. First, the average real return of the US stock market has been generous; it trailed behind only three other countries (Australia, South Africa, and Sweden). Second, the volatility of those US returns was lower than the average of the countries studied. High returns with low volatility kept U.S. stocks in the black over extended periods of time.

That will change, they argue, because stock returns will be lower in the coming years. Long-term returns are determined by where you begin the journey. The above-average returns many countries experienced in the second half of last century resulted from the willingness of investors to pay increasingly higher multiples for a stream of earnings or dividends. The authors point out that the price-to-dividend ratio in the US nearly tripled to 63.7 during the century. There's no rationale to assume that these multiples will continue to rise in the future, they say.

Current multiples have left yields historically low. The US dividend yield fell from 4.5 percent in 1900 to a recent 1.6 percent. The researchers note "The scope for valuation levels is greatly curtailed when yields start at a couple of percentage points and when P/E multiples are high relative to the past."

And there's the catch. If stock returns are lower, but there's no change in the amount those returns bounce around (and the cross-country evidence suggests there won't be), the chances of losing money are greater.

Imagine standing in the shallow end of a pool bobbing up and down. If you're tall you'll likely end up with your head above water. Your little brother may not.

Looking ahead, the authors forecast that US stocks will earn 5 percent a year before inflation. This compares to a real return of 6.3 percent in the US during the 103-year period they investigated. Among researchers who study this topic, that's neither the most bullish nor bearish prediction 2 .

If stocks do provide a real return of 5 percent a year, what's the chance of a negative real return in 20 and 40 years? The answer depends on volatility. U.S. returns have had an annual volatility of 20 percent historically. Assuming stocks stay as volatile, investors have a 14 percent chance of incurring a negative real return over the next 20 years. If investors hold stocks for 40 years, the probability of a negative real return is still about 6 percent.

Assuming a slightly higher volatility of 30 percent - about the risk of many 401K portfolios, say the authors - the chance of a negative return increases. Over 20 years, the probability of negative real return is 15 percent. Over 40 years, it's about 8 percent.

The article concludes: "Equities continue to have an important role in long-term portfolios. However, their prospective returns are lower than the performance that many investors project, while their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational."

1 Elroy Dimson, Paul Marsh, and Mike Staunton, Irrational Optimism, Financial Analysts Journal, January/February 2004.

2 For other estimates of future earnings growth and risk premiums, see: Arnott, Robert, and Peter Bernstein, "What Risk Premium is 'Normal'?" Financial Analysts Journal , March/April, 2002; Ibbotson, Roger, and Peng Chen, "Long-Run Stock Returns: Participating in the Real Economy." Financial Analysts Journal , January/February 2003; Bernstein, William, and Robert Arnott, "Earnings Growth: The Two Percent Dilution." Financial Analysts Journal , September/October 2003.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).