Financial Market Commentary

by Rob Weigand.

One of the things I find puzzling about the recent bear market is investors’ incredible sense of denial — a deep-seated unwillingness to believe that equities can lose 50% of their value in a matter of months. In my conversations with investment advisors, individual investors and endowment and pension officers, the question of “how could this have happened?” comes up again and again.

The simple answer to their question is that equities tanked because this is what they do from time to time. The behavior of equities isn’t what changes — what changes is our willingness to believe that our portfolios can be devastated by a “super bear” market tsunami from time to time.

The chart below depicts the annualized real 10-year return (dividends reinvested) that a buy-and-hold investor in U.S. equities would earn from each starting date on the x-axis (data courtesy of Robert Shiller). For example, someone who bought at the peak in 1929 and reinvested all dividends would have underperformed inflation by about -3% per year for the next decade. Conversely, an investor who bought at the market bottom in 1982 would have beaten inflation by about 13% per year for the next 10 years. A lot of investors’ current angst is probably due to the fact that buying and holding from the 1999-2000 peak yielded inflation-adjusted returns of about -6% per year. Thus the popularity of the phrase “the lost decade.”

The chart makes it clear that investors in past times have also experienced persistently negative real returns. It’s my impression that some of investors’ disbelief regarding the carnage visited upon their portfolios — and some of what’s driving the bull run from March-August 2009 — is a continued belief in the “culture of equities” propaganda that was perpetrated on investors throughout the 1990s and early 2000s.

Jeremy Siegel’s Stocks for the Long Run propagated a belief that equities were less risky than bonds in the long run. Now we realize that the research he conducted for the book was started when stocks were consistently beating inflation by double digits. It’s fair to assume that equities’ amazing performance over this period influenced his views a bit — and his unwaveringly bullish stance probably didn’t hurt his money management aspirations, either. Glassman and Hasset’s Dow 36,000 reinforced Siegel’s point of view — equity premiums have been too large historically! Stock values should be much higher! Hey, they were only off by 30,000, give or take a few Dow points.

Even Ben Bernanke told us that we were in a period he dubbed “The Great Moderation” just as the wheels were starting to come off the global economy and financial markets. Nice call, Ben. The point is that if these experts can get it so wrong — Siegel’s an esteemed Wharton professor, Glassman is a senior economist with J.P. Morgan, and Bernanke’s the Chairman of the U.S. Fed, for goodness sakes — we shouldn’t feel so bad about getting it wrong as well. But maybe, going forward, we can learn that during euphoric periods approaching market tops, popular cultures’ alleged “experts” also tend to get it wrong and give us bad advice, again and again.

I’ve redrawn the above chart with 36 month smoothing to take out some of the shorter-term wiggles and emphasize the longer-term trends. (The chart has an eerie sort of  “Elliott Wave” appeal, don’t you think?) A few noteworthy things stand out.

First, stocks’ long-term real returns can be below average — and below zero — for extended periods. Investors buying in during the 1910s, 1920s-30s, 1960s-70s, and 1990s have repeatedly suffered these agonizing fates. The returns aren’t what’s nuts — they’ve happened again and again. For me what’s nuts is the fact that, collectively, we are so eager to ignore history and embrace the delusional messages of Siegel, Glassman and Bernanke. If you instead followed the John Bogle equity allocation (100 minus your age) you still lost some wealth in the recent bear market, but not nearly as much as a culture-of-equities asset allocator.

Second, if you’re a market-timer, you’ve got to be good. If you can’t call a market bottom within a few months, the outsized real returns will pass you by. You might still perform a few points above average, and miss a few market crashes, but to do this repeatedly you need to live to be about 150 years old.

Third, after “super bear” market tsunamis, returns can languish for long periods. As a matter of fact, the only V-shaped long-term stock market recovery following a super bear began in the 1910s. The stock markets of the Great Depression and the late-60s early-70s were characterized by long, drawn-out periods of lackluster returns. So we really need a “perfect storm” type of recovery in corporate and residential real estate, credit markets, consumer spending and corporate earnings for the great bull market of 2009 to establish itself on an economically solid foundation. I’m not saying it can’t happen, but the recovery scenario needs to unfold according to a mainly positive narrative that’s occurred only rarely in the long-term history of the U.S. economy.