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The Lost Decade

April 3, 2008 by  


By Bob Wood, MMNS

The title of an article appearing in the March 26, 2008 issue of the Wall Street Journal, “The Lost Decade” refers to the barely positive returns shown by domestic stock markets since March of 1999. This premise has been at the core of the articles published in this space for almost that long and has brought home a lesson that too many investors have learned the hard way.

“The Lost Decade” article points out that returns earned by investors in the S&P 500 for this decade to date have been tepid, at best. It includes a chart showing that the index has produced an average annual gain of 2.46% since March of 1999. Assuming that government figures on inflation are credible, the average investor has barely maintained his purchasing power during these years.

Using more credible estimates for inflation that factor in steep rises in prices for commodities we use every day (such as food and energy), we find the domestic investor losing ground. And losing ground over long time periods will cause enough damage to prevent any chance of recovery.

Especially for an investor who is still working and saving for retirement, non-performance during those crucial saving years can severely alter those wonderful dreams about retirement. Investors simply cannot afford to lose this amount of time to build savings while the costs of living inexorably rise.

Another issue with the recent performance of the domestic stock markets involves the length of secular bear markets. Seldom do they end in only half the time of the preceding secular bull market. In addition, secular bear markets never end when valuations are especially high. The S&P 500 currently sports an average price to earnings ratio of about 18. And with earnings currently dropping, especially in the housing and financial sectors, at today’s level of stock prices, those P/Es are rising.

Secular bull markets tend to begin with P/E valuations about half that level. So it is possible that this lost decade is about to morph into yet another one. And that would be true to historic form, since secular bear markets tend to last an average of 18 years. In fact, the previous bull market lasted 18 years.

Making things worse for domestic investors, more credible estimates (such as those of John Williams writing at shadowstats.com) show today’s true rate of inflation running close to 10%. That means that the average investor’s portfolio needs to earn that much at a minimum — just to preserve the value of his savings in terms of what they will buy in the future.

Should the current bear market continue for another eight to 10 years, investors who believed the ‘’stocks for the long run’’ nonsense will feel real pain. And nonsense it is!

Here is my rationale for refuting the pure baloney spewed by the financial media and academics like Jeremy Siegel, author of books that feature the ‘’stocks for the long run’’ phrase. The investor who remained fully invested in an S&P 500 index fund would have earned that paltry 2.46% gain (in nominal terms) over the past nine years. Those earnings, of course, do not include taxes incurred, though they would be smaller with index funds than with many actively managed funds. It’s true that index funds are far more efficient, with underlying fees much lower than those of actively managed offerings.

But how many investors use only index funds? They invest far more money in actively managed funds since, “Hey, we all want to beat the market!” Right? The promise of market-beating returns is a powerful lure.

But we also know that most actively managed funds do not exceed their benchmarks, due partly to their higher costs. And taxes are almost always higher for actively managed funds. Then, too, many investors use ‘’helpers,’’ as Warren Buffett calls financial advisors, brokers and other salespeople. And those helpers help themselves to fees as their compensation.

Adding up those higher costs provides an estimated annual drag of about 2%, not including taxes. So if the S&P index rose by 2.45% per year, how many investors came close to achieving that figure? Most, due mainly to the underperformance of their funds, saw gains closer to flat.

And that gain potential assumes that investors stayed fully involved through all the ups and downs of the markets during those nine years. How many rode through the nasty bear market cycle during 2000 to 2002 without selling and holding the cash? How many were fully invested at the start of the bull market cycle that began early in 2003, with the S&P 500 showing a 48% loss from its earlier peak?

The folks at Dalbar, who do studies on actual investor performance over long time periods, report that their findings remain stunningly consistent. The average stock market investor garners annual returns in “up” years that are roughly half of that produced by the stock market, as shown by the S&P 500. In the best of times, investors would be better off shunning stocks altogether!

Another glaring flaw in the ‘’stocks for the long run’’ argument involves the premise that all investors remain fully invested in the S&P 500 at all times. Yet how many investors, looking for better gains, have invested in failing stocks like Enron, Worldcom, Lucent, JDS Uniphase, and, more recently, Bear Stearns, whose shares fell from $170 to a current price of about $10?

The “stocks for the long run’’ philosophy assumes that no one ever invests in stocks that lose much, if not all, value. And of this, I ask, how many car, computer and television makers; airlines, internet darlings, and biotech start-ups have gone bust in recent decades, taking investor money down the drain with them?

The idea that the stock market is a winner for investors hangs on the most delicate thread imaginable. It assumes that investors always invest wisely, never lose money in companies that go broke, never use brokers or advisors and remain invested no matter how bad things get. Oh, and it assumes that investors never chase performance — and how often does that happen?

For an extreme example of how damaging this premise can be, look no further than the experience of investors in the world’s second largest economy in Japan. The Nikkei 225 now sits at about the 13,000 level. It topped out at around 39,000 — 18 years ago!

If you think this can’t happen in the U.S., take this bit of advice. It can happen, and, in my not-so-humble opinion, will do much the same damage as experienced in Japan.

But there is hope! We can always find a bull market somewhere — and in something! But building portfolios using this theme requires breaking away from the crowd and vowing never to watch the financial media propaganda that passes for information. The Wall Street Journal article notes that, while investors in the domestic stock market have gained nothing in stocks in real terms, they have done very well indeed in emerging markets, commodities and bonds.

While our markets endure the remaining secular bear market that began at the start of this decade, other healthier economies will continue to enjoy secular bull markets. Look at markets in Asia and Europe that offer better valuations and better fiscal management than that advanced by our current administration and the Federal Reserve. Look for the continuation of those long-running bull markets in foreign markets and commodities.

This type of investing will require a different way of thinking, meaning that you build your portfolio to the exclusion of the domestic markets. And this means that nothing called a ‘’core fund’’ should be anywhere near your portfolio!

In the best of times, investors seldom earn acceptable rates of return on capital put at risk in the stock market. And these are not the best of times! These are something close to the worst of times, considering our real crisis in leadership, disastrous fiscal policies and bungled war efforts – all resulting in costs we cannot possible pay and adding considerable drag on the economy.

And with the S&P 500 sporting such high average valuations, I believe my case is solidified.

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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