Renewed fears of a double-dip recession, policy paralysis across the U.S. and Europe, and the looming threat of a financial crisis in the euro zone combined to create very volatile markets and a devastating quarter for equities.

Equity Markets
The third quarter of 2011 saw the value of small stocks and international stocks fall more than 20%, which is generally considered a bear market correction.  Large domestic stocks (S&P 500) did a bit better but fell nearly 14% in the quarter, dropping into negative territory for the year at -8.7%.

Fixed Income
Government bonds, on the other hand, had a stellar quarter, defying logic and many experts’ expectations, by rising in value after S&P downgraded the U.S. Government debt rating.  The broad bond market index, which is dominated by government securities, rose 4.7%.  The value of TIPS (Treasury Inflation Protected Securities) rose even more than the general bond market, as hope for economic recovery diminished, and action by the Federal Reserve drove expectations for real interest rates further into negative territory.  Based on the pricing of Treasury securities, and TIPS, the market now expects inflation to average less than 1.8% over the next ten years with ten-year government bonds providing a return above inflation of a meager 0.20% on average.  Government bonds of shorter maturities are expected to provide returns less than inflation, so investors’ purchasing power will diminish.

Return Expectations
We cannot predict future returns, but it can be instructive to examine assumptions built into current market pricing.  As mentioned above, the expected return on ten-year government bonds is barely above the expected rate of inflation, driven by dismal expectations for economic recovery, extremely accommodative monetary policy, and fear of another financial crisis coming out of the euro zone.  This is well below the long-term average, which is about 2% above inflation.

Stocks on the other hand appear priced to provide future returns more consistent with their long-term risk premium of 6-8% above inflation.  The S&P 500 index is at a price level first achieved in 1998, but since that time the Price/Earnings Ratio for the index (price paid per dollar of expected earnings) has fallen dramatically.  So today’s price reflects a lower, and perhaps more realistic, assumption of growth in dividends and earnings.