The harsh math of a 50 percent decline is that it requires a 100 percent gain to simply get back to even. Sure, a mere 100 percent gain seemed easy enough not so long ago. In the go-go 1990s, the S&P 500 doubled in less than three years (1995 to 1997), and then nearly did so again before the tech bubble burst in 2000. But that was then. We now live in a much stingier world.
The fact is the forces that fed the fin-de-siecle bull market simply don’t exist anymore. That’s not just recessionary gloom talking. The great bull market that ended in 2007 benefited from a gale-force tailwind not likely to be seen again in our lifetimes — a blend of falling interest rates, heedless spending by both businesses and consumers, and the once-in-a-generation technological breakthrough known as the Internet.
While Fed chair Ben Bernanke is pulling every lever possible to get us through the financial crisis, interest rates must eventually rise, not fall, from here. We Americans need higher rates to convince our creditors (including China and Japan) to keep buying our ever-growing debt. As rates rise, the substitution effect will come into play, according to Sam Stovall, head of S&P’s Equity Research. It makes less sense to buy stocks if you can pocket a competitive yield in a comparatively much safer bond. Consider that from 1962 (the last period that the 10-year Treasury yield fell below 4 percent) to 1982 (when the 10 year T-note peaked at 15 percent), the S&P 500 gained an annualized 7.4 percent. At that pace we’re still eight years from breaking even.
Jeremy Grantham, co-founder of the $78 billion GMO investment management firm and one of the few professionals to emerge from the crisis with his reputation actually enhanced, reached the same conclusion. As he wrote in a recent shareholder letter: “With [price-to-earnings ratios], profit margins, and GDP growth all lower than average, it’s very unlikely that we will get back to the old highs in the stock market in real terms anytime soon — at least not for seven lean years — and perhaps considerably longer.”
The Next Decade Will Be Better Than the Last
As dour as the market prognosis may sound — these days the word sober always seems to precede the word prediction — the news is actually fairly positive if you focus farther out. After a 50 percent haircut, it’s a pretty good bet that the froth is out of the market. And for the first time in more than a decade, a return to normal market values would work in our favor. The gains may not be spectacular, but at least they should be gains. Indeed, even yesterday’s bears sound upbeat. Grantham, who had been accurately predicting the collapse of the S&P for years, now sees stocks climbing, and he actually thinks investors in emerging markets and U.S. blue chips will see annualized gains of 10 percent or more after inflation over the next seven years.
Another noted contrarian, Rob Arnott, head of $15 billion Research Affiliates investment firm, is also tilting bullish. “Today, we find ourselves in an unaccustomed position: We’re optimists in some markets,” he wrote in a recent newsletter. Jason Hsu, Arnott’s chief investment officer, says the firm still sees the glass as at least half full despite the market’s quick rally off its March low. “We are definitely more optimistic right now than we have been. We reliably know that earnings grow about 5 percent, and dividends right now are at 3 percent; that gets us to an 8 percent annualized return. That s a good target based on real data, not the inflated data of the past 10 years,” says Hsu.
In a rare moment of market generosity, it looks as if the sleep-at-night stocks may also hold the promise of the best returns. Firms such as Coca Cola and Procter & Gamble, which have a proven ability to generate earnings and pay dividends, are the sweet spot in a slow-growth environment. “For the past 15 to 20 years, growth came from taking on risk,” says Judith Saryan, who manages several mutual Eaton Vance funds that focus on stocks paying generous dividends. “Now we are in a period when corporations will need to pay down their debt. In this new environment, companies with solid balance sheets and proven sustainable earnings growth — and plenty of cash on hand — are going to be more attractive. ”
In recent years it’s been easy to forget that 44 percent of the S&P 500’s return has historically come from compounded dividends. Sure, in late 1990s dividends accounted for less than 20 percent of total return, but that was because stock prices rose to unrealistic levels. Now that we’re back to reality, dividends will once again matter. And it’s not too late to get in. “We see plenty of high-quality U.S. firms that are cheap, and that’s the nicest thing I can ever say about an asset class,” says Ben Inker, head of asset allocation at GMO.
That’s not to say there are no growth stocks worth buying; you just need to whip out your passport. The International Monetary Fund estimates the GDP growth for emerging markets between 2011 and 2014 will be double the growth of developed markets (around 6 percent a year compared with less than 3 percent).
Take Action: Simply by owning an S&P Index fund (Schwab’s is now the cheapest), you’ll have exposure to blue chips, which have a heavy weighting in the index. You can make a more focused bet on quality stocks with a fund such as the Jenson Portfolio (JENSX), which only invests in companies with long records of high profitability. Inker suggests that you divide up your stock portfolio the way that stock-market values are divided around the world: 45 percent of world capitalization is in U.S. stocks, 45 percent in other developed nations’ markets, and 10 percent in emerging markets.
Your Returns Will Be Higher Than They Were During the Bull Market
OK, that’s a bold statement. But the sad truth is that most investors had bupkes to show for the great bull market, even before the crash. If you only keep one statistic in mind when investing, it should be this: Over the 20 years ending in 2008, the typical investor earned an annualized 1.9 percent from stock funds and 0.8 percent from bond funds, according to research firm Dalbar. Over the same stretch the S&P delivered an 8.4 percent annualized return and the Lehman Aggregate Bond index an average 7.4 percent rise. The big disconnect between market returns and portfolio returns is almost entirely self-inflicted: By chasing hot markets and fleeing cold ones, investors market-timed themselves out of one of the great bull markets in history. The market delivered, but investors squandered the opportunity by selling low and buying high.
So our prediction is a vote of confidence in you: Instead of throwing away 75 percent of the market’s returns, you will capture most of the expected 8 percent annualized gain, thereby tripling the average investor’s take from 1988 to 2008. The key to success is to do less. Trade less. React less to every market twist and turn. Settle on a long-term allocation strategy and invest in low-cost index funds that allow you to keep your returns instead of handing them over to a mutual-fund manger. Rebalance once a year, and then forget about it.
One More Bubble Will Pop
The financial markets may have one more heartbreak in store for us. “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s,” Warren Buffett wrote in his most recent letter to Berkshire Hathaway shareholders. “But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.” Terrified investors rushed into Treasury bonds as stocks crashed, driving prices higher and yields down to historic lows. “Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long,” declared the Oracle of Omaha. “Holders of these instruments, of course, have felt increasingly comfortable (in fact, almost smug) in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim cash is king, even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.
Inflation is nonexistent at the moment, and the great inflation-deflation debate rages. But set your gaze out a few years and inflation is harder to dismiss. If inflation were to clock in at 4 percent — about the long-term trend — intermediate or long-term bonds become downright dangerous. Even one- and two-year Treasuries are problematic. They yield less than 1 percent; if inflation ticks up from moribund to merely normal, that translates into negative real returns.
Grantham, in fact, said recently that he was selling long-term government bonds short; GMO’s seven-year forecast sees government issues as a whole barely clocking a real return above 1 percent. Dividend-paying stocks offer a better risk-reward profile (assuming you aren t using the money for an emergency fund): “I can get the same yield on the S&P that I get from a Treasury, and I have the upside from the stock,” says Hersh Cohen, chief investment officer of ClearBridge Advisors
Take Action: If you want the full faith and credit of the U.S. government backing your emergency cash fund, consider an FDIC-insured money market fund; returns should climb with prevailing interest rates. For government backing of longer-term investments, you can get inflation protection with Treasury Inflation-Protected Securities (TIPS).
For the rest of your fixed-income stash, peel your eyes away from Treasuries. “Five years ago you gave up nothing to get safety; a two-year Treasury had the same yield as a high-grade corporate bond,” points out William Bernstein, author of The Four Pillars of Investing. “Now the price of that safety is extremely high. You can get paid near 5 percent from an index of high-grade corporate bonds or about 0.85 percent from a short-term Treasury.” Do you really want to turn your back on an extra 4 percentage points?
The great bull market may not be coming back soon, but smart investing in a low-return environment may deliver plenty of profits. Yes, there will be no flash. But as Buffett wrote in his annual letter, “Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
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