My Two Cents

History Rewards the Stalwart Investor

Chris Farrell Jan 5, 2009

My latest essay:

These are unnerving days, with fears of an extended recession replaced by growing worries of a Depression. During such times, it’s natural to look back at history for lessons to provide perspective on the current crisis. A first glance at the market’s performance in deeply unsettled times isn’t pretty: During the Great Depression, the Dow Jones industrial average plunged 89% from its 1929 peak to its 1932 trough, partially recovered over the next five years, then tumbled a further 52% between 1937 and 1942.

Delve deeper into the history of the markets, though, and you can find valuable lessons, starting with the reminder that volatility in the Dow is nothing new. While many investing mantras haven’t held true in recent history–consider how ineffective the investing trinity of diversifying, buying and holding stocks, and dollar-cost averaging has been over the past decade–there is a discernible rhythm over the long history of the markets. And it offers glimmers of hope to harried investors.

Specifically, the despair and low prices that mark financial catastrophes set the stage for higher prices and loftier returns later on. “Markets tend to overshoot in both directions,” the late financier Leon Levy wrote in his memoir, The Mind of Wall Street. “Just as we saw stock prices rise far above the value of the companies, we are likely to see the reverse. Stocks will then be undervalued, and there will be new opportunities for investors.”

Here’s the rub: The timing of the recovery is uncertain. Take Levy’s book. It is, in many respects, a prescient tale of today’s environment, with an emphasis on the overly indebted consumer and Wall Street’s irresponsible financial wizardry. It was published in 2002, but it really took another five to six years for the deep reversal he anticipated to materialize. But compare this with the debacle of the 1930s: The Dow’s 17% drop in 1929 was followed by a 34% decline in 1930, a 53% drop in 1931, and a 23% fall in 1932. “In 1931, people would say, ‘How bad can it get? This must be the bottom. I’ll buy,” says Eugene White, an economist at Rutgers University. “Six months later, you’d have lost everything.”

Timing aside, there’s no denying that the stock market looks increasingly tempting. By one measure, equities are priced lower against Treasuries than at any time since 1958: The current dividend yield on the Standard & Poor’s 500-stock index is almost 3.3%, compared with a 2.2% yield on the 10-year U.S. government bond. Stocks typically carried higher yields than Treasuries before 1958. That reflected the fact that investors viewed stocks as far riskier than bonds and meant companies had to pay out large dividends to attract shareholders.

But that cautious mindset changed during the postwar euphoria of the 1950s. Despite a global economic contraction and an auto industry slump that led to 20% unemployment in Detroit, in 1958 the S&P 500’s dividend yield fell below the yield on Treasuries and stayed below those on government bonds until now, a half-century later. The 1958 shift reflected investors’ diminishing fears of another Great Depression, as well as rising confidence in Corporate America’s earning power. But investor emotions have come full circle again, and markets have priced in a worst-case scenario. “Right now, there are a lot of depression probabilities built into stock prices,” says Jeremy Siegel, a finance professor at the Wharton School.

It isn’t just depression risk that’s rattling investors. There’s the prospect of deflation, or a decline in overall price levels, and what that might do to corporate earnings. (Inflation and deflation are mirror images of one another.) For instance, price levels plunged by a quarter during the Great Depression, and the rapid decline erased company profits. Investors are also struggling to figure out whether fiscal and monetary policy will work to resuscitate the economy. During the Great Depression, equity investors suffered a -20.2% real return from 1929 to 1932. But thanks to investor optimism following the election of Franklin D. Roosevelt and his Administration’s New Deal activism, the stock market soared by a record 66.7% in 1933–the biggest one-year gain of the entire past century.Problem is, the market gave up those gains and more, making the 1930s the most volatile decade in U.S. history. “After 1929, people questioned the fundamental premise of investing in the stock market,” says William Goetzmann, a finance professor at the Yale School of Management.

The public’s reaction was understandable, but shunning stocks is the wrong lesson for today’s investors. For one thing, the investment record of equities looks different when deflation is relatively mild. From 1872 on, the stock market rose annually by an average 13.9% for 24 years that featured mild deflation–of around 1% to 2% a year. That’s second only to the 15.6% average gain achieved during periods characterized by modest inflation.

Moreover, stock market data support the notion that it’s smart to own riskier assets after a long stretch of poor performance. The S&P 500 has had an average annual return of 0.9% over the past decade. Steve Leuthold, chief investment officer for the Leuthold Group and a market historian, looked into performance for every decade since 1926: The past 10-year period ranks among the bottom 4%. Yet after each of the worst 10-year periods, the market returned no less than a 7.21% compound annual return the following decade, and the best decade-long return was 15.58%, in 1974-84. Put differently, young investors bold enough to gamble on stocks during the Depression’s dark days would have seen their stake grow tenfold by the time they reached retirement in 1957, notes Oxford historian Niall Ferguson.

The stock market rewards the intrepid because most investors steer clear of equities after a debacle. Blue-chip stocks in the 1950s offered dividend yields of 5% to 7%, but the generation that had been burned by the bear market of the 1930s shunned equities. Investors fled stocks in the inflationary ’70s, and it took another decade before individuals again embraced equities. This time around, it’s likely that many workers will decide that government bonds such as Treasury Inflation Protected Securities, and not stocks, should form the foundation of their retirement portfolio. “The poor individual investor has been hit by the 2000-02 downturn and then, eight years later, there’s a second big hit,” says Leuthold.

Of course, it’s impossible to know whether the market is hitting bottom now–or might do so in a year. That’s why the old proverbs that preach diversification and dollar-cost averaging remain good advice for anyone investing for the long haul. Diversification isn’t a hedge against any financial crisis over a short period of time. “After that, the most mispriced asset classes come back more strongly than others,” says Ross Levin, a financial planner and head of Accredited Investors in Edina, Minn. “Rebalancing is critical during these periods. By systematically rebalancing, you are forcing yourself to buy low.”

Indeed, it’s at times like the present that dollar-cost averaging really pays off. It pushes the investor away from trying to time the market. For instance, investors earned a real 2% average annual return on their equity investments during the 1930s, according to Ibbotson Associates, a market research firm. But they pocketed a real 7.1% on their government bonds and 2.7% on short-term Treasury bills. Yet during the 1950s investors earned a real average annual return of 16.8% on stocks, while losing 2.2% on bonds and 0.3% on bills. “Timing is a tough business,” says Paul Samuelson, the 93-year-old Nobel laureate economist who was a pioneer in modern financial theory. “It’s easy to sell, but then you have to know when to get back in–and we know that hardly anyone is good at it.”

The fact remains that stocks and bond are risky. And stocks are riskier than bonds because equities represent the rewards for entrepreneurship, while bonds are contracts that spell out when borrowers must make principal and interest payments. “It’s really useful for us today to look at history and know that we’ve had panics and crises before, and that markets recover,” Goetzmann says. “Even taking into account the 1930s, stocks have been a good investment. I take comfort from that.” Investing in a diversified portfolio still pays for anyone with time–and fortitude–on their side.

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