Revisiting the Lost Decade

Equity market returns for 2013 were nothing short of outstanding. The S&P 500 made its largest gain (+32.4%) since the heady days of 1997, while small company stocks did even better with a gain of nearly 39 percent. European stocks also did well (+26%) with Germany leading the way (+32.1%). Even the troubled economies of Greece, Spain and Portugal posted positive, albeit, single-digit returns.

On the other hand, fixed income markets struggled as they grappled with the reality of rising interest rates. Bonds with longer maturities and those with higher credit quality suffered the greatest. Investment grade bonds, as measured by the Barclays Capital Aggregate Index, fell 2.0%, while intermediate-term treasury bonds dropped 6.5% and long-term treasury bonds lost 12.7%. Only high yield bonds produced a positive return, gaining 7.4% on the year.

The “Lost Decade” recovered

Remember the doom and gloom feelings of 2008? Real estate values were collapsing, banks were failing, businesses were retrenching and employment was imploding. Market pundits were wringing their hands over the “lost decade” and several worried that the markets were broken and couldn’t be trusted. David Weidner at the Wall Street Journal channeled the frustration many of us felt when he lamented on October 15, 2009, “We’ve spent the last decade spinning our wheels only to find we were walking in place.” He went on to give us a lesson in basic market math: “If you invested $100 in the S&P 500 at the end of the last decade [1999]…you’ll need a staggering 72% rally, when adjusting for inflation, [just to break even.]”

Well, Mr. Weidner, I am pleased to say that with 2013’s rally, we have recovered what was lost in 2008/2009 stock market meltdown (and then some), even after adjusting for inflation. While the return on the S&P 500 for the past 14 years was nothing to write home about (a mere 3.6% average annual compounded return), at least we are once again earning a return in excess of inflation. Patience gets its due.

Talking about “lost decades” begs an interesting question: How likely is it that stock market investors will fail to keep pace with inflation over a 10-year period? The answer, at least in historical terms, is “not very”—as this chart illustrates.

Since 1926, there have been 10 instances of negative 10-year real returns: 7 occurred during the high inflation of the 1970s and early 1980s, and 3 occurred during the financial crisis from 2008 through 2010. The following table shows that the longer the investment horizon, the less likely an investor will experience negative real returns. In fact, with a 15-year horizon, the incidence of negative real returns drops to 5 percent. With a 20-year horizon, it disappears completely.

The message I take from this table and the preceding chart is that investing requires patience, per­spective and a careful matching of investment strategy to the invest­ment horizon. The longer the hori­zon, the more equity exposure is appropriate and the greater patience you should exercise. Over a full market cycle there will be good times and bad times (and maybe even some REALLY bad times), but have faith. The market has proven itself to be wonderfully resilient.

Where next?

Last year’s remarkable run has everybody wondering, “Where next?” I admit that I don’t know. I gave up crystal ball gazing a long time ago. But here are some things that give me confidence in 2014:

  1. There is still a lot of money sitting in bond and money market funds. According to the Investment Company Institute, more than $1.3 trillion moved into bond and money market funds between 2007 and 2012. During the same period, $612 billion moved out of domestic equity funds. In 2013, those flows experienced a slight reversal as $58 billion moved out of bond and money market funds and $28 billion moving into equity funds. If that slight trickle was able to help spark last year’s monster rally, what might happen if that trickle turns into a flood?
  2. Just because we enjoyed a powerful rally last year, doesn’t mean we are doomed to a subpar year in 2014. In fact, a survey of the top 20 years for the S&P 500 in the post-war era shows that 16 had positive returns and 11 of those had returns greater than 15%.
  3. The U.S. economy seems to finally be getting some traction. Labor markets, though still tepid, are improving. Business confidence is increasing. Home builders are back, breaking ground on new construction at their fastest pace since February 2008.

With these factors, and many others, so favorable, I see few reasons for fear. Though the stock market may decline, there is little that might spark a collapse. We recommend investors hold a steady course, focusing on their long-term objectives. You can always count on us to do so.

Steve Merrell is a CERTIFIED FINANCIAL PLANNER (CFP) practitioner in Monterey, CA and is a co-founder and financial advisor of Monterey Private Wealth.  Monterey Private Wealth is a fee-only investment advisory firm, which serves the communities of Pleasanton, Dublin, Blackhawk, Danville, San Ramon, Livermore, the greater San Francisco Bay Area, Monterey, Carmel, and the greater Monterey County Area.