A Lost Decade For Equities

Discussion in 'Wall St. News' started by PAPA ROACH, Feb 11, 2008.

  1. February 7, 2008 3:59 p.m. EST


    A Lost Decade For Equities


    The recent tumble in the markets has the airwaves filled with sober advice from financial talking heads about how investors should "stay the course" at times like these, touting the long run merits of sticking with stocks.

    Their point about not panicking or abandoning long-term financial plans certainly is sound, but the reassurances they give about allocating a big portion of savings to stocks ring hollow because bear market losses are devastating and can take a long time to erase. Most people assume that this refers to nasty periods like the 1930s or the 1970s, turbulent times in history well before most current investors had bought their first mutual fund or were even born, but one doesn't need a depression or stagflation to crush stock returns -- the last decade was bad enough.

    Through the end of January, the 10-year total return for holding the Standard & Poor's 500 was just 5.14% annualized while a basket of investment grade bonds represented by the Lehman U.S. Aggregate Index returned 6.015%. In other words, $1,000 invested 10 years ago would have grown to $1,651 owning just stocks and $1,793 owning virtually riskless bonds, while holding the average U.S. large growth stock fund would have returned an even lower $1,512.

    Triumph Of The Pessimists

    "There will be any number of trailing periods over the past century when it would have been a bum deal to own equities," said Christine Benz, director of personal finance at Morningstar Inc.

    What is surprising is that one such bum period came in what seems like a pretty good time to have been in stocks overall. There were almost eight years of bull markets versus just over two years of a bear market. What's more, two and a half of those years were the crescendo of the greatest bull market of all time.

    For a generation of investors weaned on a quarter century of mostly solid market returns and books like "Stocks for the Long Run" and "Triumph of the Optimists," the long run superiority of stocks over bonds is accepted as holy writ. Over the very long run, the evidence is clear that stocks outperform risk-free securities by four or five percentage points, adding up to returns over a century that are many multiples of what one would get holding bonds, but the picture is a lot different over periods of a decade or even two.

    Professors Elroy Dimson, Paul Marsh and Mike Staunton, authors of "Triumph of the Optimists' are often cited as key proponents, along with Jeremy Siegel, of sticking with stocks. But Dimson, Marsh and Staunton actually strike a far more cautionary tone. In a 2003 paper, "Irrational Pessimism," the three academics sliced 103 years of U.S. equity returns into rolling 10 year chunks and calculated that the bottom tenth of total annualized returns fell in the range of -4% to -0.9%. Even the bottom fourth only went as high as +2.8%. The problem is that losses are far more devastating than gains of the equivalent magnitude.

    "Because of the mathematics of compounding, large losses have a disproportionate effect on cumulative returns," writes fund manager and former finance professor John Hussman. "Remember that historically, most bear markets have not averaged 20%, but approach 30% or more. A 30% loss takes an 80% gain and turns it into a 26% gain."

    In the past decade, spectacular gains of 55.2% from January 1998 through September 2000 and an additional 101.5% from Oct. 9, 2002, through the recent peak on the same date in 2007 were whittled down by the 2000-2002 bear market that cut the S&P nearly in half and the 12% drop from the recent peak through the end of January. People holding bonds over this period could not only sleep soundly at night but beat equity investors, despite missing out on two bull markets.

    "It does exemplify how hard it can be to dig out of a bear market, even with a great bull run from 2003 to 2006," said Benz.

    Rip Van Winkle

    Of course, the longer one stays in stocks the better the odds of outperforming risk-free investments, but even 20 years doesn't guarantee the sort of returns in the high single digits or low teens that the 1980s and 1990s bull markets led us to see as normal. Ed Easterling of Crestmont Research sliced the total annualized return for the Dow Jones Industrials into 20 year periods from 1919-2003 and found that that bottom decile had returns from 1.2% to 4.5% and the next two only got as high as 5.4%. Only the top three deciles crack the double digits. What's an investor to do? An extreme solution would be to establish some criteria for when stocks are expensive and, as Hussman puts it, act like Rip Van Winkle, oblivious to what is happening in the meantime.

    Backtesting the result over 50 years, Hussman found using his parameters led to a threefold outperformance of the S&P 500 and only 11 moves in or out of stocks over that time, missing big rallies like the 1990s as well as big drops like the ensuing bear market.

    "I wouldn't recommend old Rip's strategy in practice. It would be psychologically impossible to follow, and there are far better ones that capture greater gains with more controlled risk," he wrote. "Still, the Rip Van Winkle strategy illustrates an essential point: advances in overvalued markets are regularly given back at great cost to investors who overstay, and can be avoided at no cost to long-term investors."

    Timing the market in such an extreme way would be anathema to mainstream investment advisors, but toning down the advice to stay fully invested through all types of market cycles might be wise. "You have to be in it to win it" should be balanced by a frank understanding that many years of patient gains can be whittled down by a much shorter bear market. Asset allocations are generally based on age and not on how frothy the equity market is compared with the past, but the last decade -- not an extreme period by any measure -- shows that it pays to be a pessimist sometimes.

    (Spencer Jakab previously wrote the STREET SAVVY column, which has been rebranded as TAKING STOCK, a new global column which gives insightful analysis about equity-related topics around the world.)

    ---By Spencer Jakab, Dow Jones Newswires, 201-938-2429; spencer.jakab@dowjones.com