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 May 2008 Lose the Lost Decade Time Isn't Always on Your Side
Along those lines, sometimes a picture is worth a thousand words, but then there are times when it's not worth the media it's printed on. As a case in point, consider Chart 1 which compares the price appreciation of the Dow Jones Industrial Average to the Consumer Price Index (CPI) from November 1999 through March 2008. This chart -- or ones quite similar -- started appearing in early-April along with dour commentary about the U.S. investors' "Lost Decade". The "lost decade" allusions are a reference to Japan's moribund economy in the 10 years following the collapse of the Nikkei in the early 1990s. That was the result of a real-estate fueled runup and subsequent implosion. Is there a valid parallel to current U.S. conditions?
Indeed, from December 31, 1999 through March 10, 2008, the Dow was up a miniscule 2.11% while inflation was roughly 30% higher. Stocks were not only sluggish, they were actually negative in real terms. This is surprising given the strong rally and bull market that existed from 2003 until just recently. Didn't it feel like stocks were doing a lot better? Yes, this data is correct and the chart certainly makes its point, but before losing all confidence in domestic equities, it's important to put this into the correct perspective. Let's see if we can separate the facts from mere appearance.
What's Normal? Of course one might argue that all these points are carefully picked to show the extremes in the averages' movements. Indeed, they are, but then no more than the selection of December 1999 as the starting point for Chart 1. For almost any given level of the average, you can always go back ten or even twenty years and find a similar point. Does that mean it's always a lost decade or two? Volatile markets will always afford such opportunities. The steadily trending markets of the past two decades have lulled investors into expecting that to be the norm rather than the exception. It hasn't always been that way as you can clearly see from Chart 2 which shows the Dow's 10-year rolling period returns from 1926.
The Great Depression left a lasting mark on stocks well into the 1940s. Ten-year gains were uncommon at that point. That shifted with the boom after World War II, launching a 25 year period of 10-year gains peaking around 1960. After that, the gains declined until the "stagflation" of the 1970s led to a series of 10-year losses. The Reagan resurgence brought another period of gains that still persists despite what you see on Chart 1. If two in a row is a pattern, one might be inclined to think that the Dow moves in roughly 30-year cycles of 10-year gains. The positive cycles take on an almost normal distribution, rising for half the period and then almost symmetrically decaying over the second half. Full cycles are separated by roughly ten years of choppy results frequently marred by 10-year losses. If that's a fair assessment, the Dow is just about due for one of those choppy periods. There are investors who believe markets move in multi-year "waves" so this isn't as far-fetched as you might think. Perhaps every market is due for a lost decade every forty or fifty years or so. But does the fact that you can find two points where stocks have been at roughly the same level mean the overall market has been behaving abnormally? If returns had been consistently around 0% from month to month and year to year, then it certainly would have. But that's not been the case over the past seven years and it didn't happen in Japan's lost decade, either.
In fact, if you look at the Dow's statistics since December 1999, share price movements have been remarkably normal. Monthly returns ranged from +10.6 to -12.4, well within the range of +25.4 to -14.5 representing one standard deviation of historical returns. Average annual return was somewhat less than the historical average, 1.4% vs. 5.4%. As you'll notice from Chart 4, the distribution pattern of monthly returns was quite similar to the historical distribution dating back to 1926 on Chart 3. The one major difference is in the extremes or "tails" of the charts. Rather than displaying large swings both on the up and downside, most returns were bunched around the average. This is precisely what you'd expect for a normal distribution over Chart 4's shorter time frame. If anything, this is the mark of a normal market, not a "lost decade".
Real Meaning Secondly, the decrease in volatility does not indicate that money put into the market during the period was in any way "lost", whether it be relative to inflation or even in absolute terms. This isn't to say that someone going all-in in December 1999 wouldn't have been essentially flat in March 2008; they would just as illustrated by Chart 1. But the story would have been entirely different for the trader who jumped in in the fall of 2002 or cashed out five years later. Either way, he or she would have enjoyed double digit gains. Thirdly, investment gains over the period weren't just limited to traders. Even a buy-and-hold investor who entered the market in 2002 would have had a nice return by March 2008. In fact, it's only those who bought in at the Dow's peaks over the period that would be flat or have a loss. That's actually where the lesson is. Although proponents of a buy-and-hold strategy often say, "It's time in the market rather than timing the market that counts," here's a case where it does. In fact, it always does for all investors. Buy-and-hold investors don't intend to time the market by jumping in and out, nevertheless they can greatly improve their returns by considering the timing of their purchases.
Time will certainly heal all wounds, but why go through all that? When the market has been on an upswing for a prolonged period and if valuations are above average, odds are there will be a correction in the not too distant future. By waiting for that to occur, even the buy-and-hold investor can increase returns. In this case, simply waiting a few months after December 1999 not only would have improved results over the next 7+ years, it would have also limited the downside at the outset. Even buy-and-hold investors need to consider the timing of their purchases. Finally, it's time to stop seeing history repeat itself in every little short-term event. Investors -- spurred by the media -- have been programmed to jump to conclusions with every new bit of data. Ever since tech stocks collapsed in the late 1990s, any indication of overvaluation has been labeled a "bubble". Today commentators speak of the "housing bubble" and the "credit bubble". Others foresee a "commodity bubble" on the hoof. Financial markets went years and years without asset pricing bubbles, why is everything in such a lather now? Could it be that it's not? Quants are notorious for searching for patterns in the market, often looking for history to in some way repeat itself. Where they differ -- and differ significantly -- is the fact that they don't always see events as happening in the extreme. The fact that gold prices pierced $1000 an ounce doesn't necessarily mean there's a gold bubble. Falling home prices don't necessarily signify the collapse of a housing bubble. The fact you can find a point in the recent past when stock prices were near current levels doesn't have to mean there's been a "lost decade". Sometimes -- indeed, in most instances -- periods of normal return distributions and lower volatility are simply that: Periods of normal return distributions and lower volatility. Sometimes things are just what they seem to be. That's the case with the current "lost decade". So think about it before you swallow the latest fad fear. Yes, history repeats itself, but not always to the wildest extreme -- and rarely in February and May although those are the television sweeps months. Here's to leaving the bubbles aside and forgetting about lost decades. Sometimes the light of common sense can dispel even the scariest hyped-up shadows. Search this site! Just enter you key word or words:
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UMBERS ARE IMPORTANT to investors, particularly quants who base their investment decisions on historical trends and patterns. But even if the numbers don't lie, sometimes they mean less -- much less -- than they appear to. It's always important to step back and put the data into perspective before drawing a final conclusion.
