Stock Market: Reassessing Fairy Tales

The U.S. stock market is on track to deliver its worst decade of performance on a calendar-basis since the record keeping began on such things, we’re told. Shocking as that is, it’s not the end of the world, although it does reveal a few things about what’s been happening in equities (and the collective mind of investors) over the years.

“Unless there’s a significant rally in 2009, the 2000s will prove to be the worst performing US stock market decade ever, actually losing money for the first time,” writes Ron Surz of PPCA Inc. (an investment analytics/software firm) in a research note today. “It will take a whopping 40% return in 2009 to make investors whole for the decade.”

The context for this increasingly likely outcome for this decade is driven home in one of Surz’s graphics, which we reproduce below:

S&P 500 Returns

What stands out in the above graph is the seemingly abnormal behavior in equities for this decade thus far. If you listen carefully, you can almost hear the cries of anguish and anger around the country as investors come to grips with the fact that for the first time the cupboard is bare—and shrinking— for equity returns in this decade.

The losses in U.S. equities generally will bring a fair amount of pain and suffering to investors near and far. Is this a sign of the financial apocalypse? Does it mean that equity investing is no longer compelling? Or is there a larger truth here?

Your editor comes down on the side of the latter. That doesn’t make things any easier, of course. Nor do we want to minimize the genuine hardship that such an extraordinary equity loss has and will inflict on investors via their 401(k) accounts, pension funds and other financial holdings. But let’s also recognize that what’s shaping up to be an unprecedented decade of hammering for the stock market shouldn’t come as a total surprise.

Indeed, there is no law in the universe that says that stocks must deliver positive returns during each and every 10-year calendar stretch. Indeed, there’s nothing magic about measuring returns in one 10-year period that begins on December 31 and ends exactly 120 months later. To the extent that 10-year records (or other time periods) are worth reviewing in search of broad investment trends, one might also consider looking at rolling time series. But we digress.

As to calendar-based decades, positive performance has been the trend in the past, largely because the U.S. economy has a habit of growing over time, which in turn dispenses various financial treats for corporate America and their shareholders.

On that note, how does the record on GDP growth compare with the rise in corporate profits? For a summary, consider the following:

GDP vs Co. Profits

Clearly, the trend of late in corporate profits has deteriorated to the point of contraction. Although the U.S. economy was still growing as of last year’s third quarter, the Q4 GDP update is widely expected to go negative too.

Over the longer term, however, it’s also clear that corporate profits and GDP have been rising, and therein are the key drivers of the stock market’s gains over the years. In fact, so far in this decade, through last year’s third quarter, GDP and corporate profits remain in the black. Last year’s fourth quarter and this year will be another matter. But leave that aside for a moment and recognize that the decade through 2008’s third quarter looks about par for the course, if not better.

How, then, could the stock market be posting a loss for this decade? One possible explanation starts by looking at the 1-year bar for corporate profits in the graph above. The steep loss in profits is, of course, widely recognized by investors, and its arrival has been expected for some time—thus the falling stock market over the past year or so. Yes, GDP for the year through 2008’s Q3 was still holding up, but that too shall tumble once numbers for Q4 and beyond are published.

Still, why should the stock market returns behave any differently in this decade vs. previous decades? Economic recessions and tough times for corporate profits are old hat and yet the stock market’s managed to post gains in each decade from the 1940s on. What’s changed this time?

The answer, we believe, lies in the extraordinary bull markets (may they rest in peace) of the past 20 years. The party, if you will, got a bit overextended and now we’re knee-deep in cleaning up the mess.

If you go back to the first chart above you’ll note that the 1980s and 1990s witnessed unusually strong gains in the stock market. Until recently, those gains were extended in the 2000s to similarly sky-high heights. The idea that three unusually robust, back-to-back decades of stock market gains were possible, much less assured, was a fairy tale, of course.

Were there any warning signs that the fairy tale was destined to crumble? Absolutely, although timing was always debatable. But the clues were out there and many observers of the capital markets had been pointing them out for years. Most investors ignored the warnings, and thought that was no risk involved. But the proverbial jig is now up. A clear grasp of the obvious, as a result, is now widely circulated among formerly disengaged investors the world over. Some might even go so far as to call that progress, along with a few other choice names.

If we use the widely cited 10% average return for stocks in the long run, one can well imagine that this decade will have to give back some of the above-average returns earned in the 1980s and 1990s. Painful? Yes, but if you were thinking otherwise you were expecting too much based on the historical record.

The good news is that expected returns for U.S. equities look pretty good, at least by historical standards. No, that’s not a prediction that 2009 will be a banner year for equities. But after so much carnage, prospective returns in equities are now encouraging. Why? For the same reason that the outlook for equities in early 2007 looked discouraging: valuation.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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