Fairy Tales: Reassessing the Market Mindset

The U.S. stock market is on track to deliver its worst decade of performance on a calendar-basis since the record keeping began on such things, we're told. Shocking as that is, it's not the end of the world, although it does reveal a few things about what's been happening in equities (and the collective mind of investors) over the years.

"Unless there’s a significant rally in 2009, the 2000s will prove to be the worst performing US stock market decade ever, actually losing money for the first time," writes Ron Surz of PPCA Inc. (an investment analytics/software firm) in a research note today. "It will take a whopping 40% return in 2009 to make investors whole for the decade."

The context for this increasingly likely outcome for this decade is driven home in one of Surz's graphics, which we reproduce below:

What stands out in the above graph is the seemingly abnormal behavior in equities for this decade thus far. If you listen carefully, you can almost hear the cries of anguish and anger around the country as investors come to grips with the fact that for the first time the cupboard is bare — and shrinking — for equity returns in this decade.

The losses in U.S. equities generally will bring a fair amount of pain and suffering to investors near and far. Is this a sign of the financial apocalypse? Does it mean that equity investing is no longer compelling? Or is there a larger truth here?

I come down on the side of the latter. That doesn't make things any easier, of course. Nor do we want to minimize the genuine hardship that such an extraordinary equity loss has and will inflict on investors via their 401(k) accounts, pension funds and other financial holdings. But let's also recognize that what's shaping up to be an unprecedented decade of hammering for the stock market shouldn't come as a total surprise.

Indeed, there is no law in the universe that says that stocks must deliver positive returns during each and every 10-year calendar stretch. Indeed, there's nothing magic about measuring returns in one 10-year period that begins on December 31 and ends exactly 120 months later. To the extent that 10-year records (or other time periods) are worth reviewing in search of broad investment trends, one might also consider looking at rolling time series. But we digress.

As to calendar-based decades, positive performance has been the trend in the past, largely because the U.S. economy has a habit of growing over time, which in turn dispenses various financial treats for corporate America and their shareholders.

On that note, how does the record on GDP growth compare with the rise in corporate profits? For a summary, consider the following:

Clearly, the trend of late in corporate profits has deteriorated to the point of contraction. Although the U.S. economy was still growing as of last year's third quarter, the Q4 GDP update is widely expected to go negative too.

Over the longer term, however, it's also clear that corporate profits and GDP have been rising, and therein are the key drivers of the stock market's gains over the years. In fact, so far in this decade, through last year's third quarter, GDP and corporate profits remain in the black. Last year's fourth quarter and this year will be another matter. But leave that aside for a moment and recognize that the decade through 2008's third quarter looks about par for the course, if not better.

How, then, could the stock market be posting a loss for this decade? One possible explanation starts by looking at the 1-year bar for corporate profits in the graph above. The steep loss in profits is, of course, widely recognized by investors, and its arrival has been expected for some time — thus the falling stock market over the past year or so. Yes, GDP for the year through 2008's Q3 was still holding up, but that too shall tumble once numbers for Q4 and beyond are published.

Still, why should the stock market returns behave any differently in this decade vs. previous decades? Economic recessions and tough times for corporate profits are old hat, and yet the stock market has managed to post gains in each decade from the 1940s on. What's changed this time?

The answer, we believe, lies in the extraordinary bull markets (may they rest in peace) of the past 20 years. The party, if you will, got a bit overextended and now we're knee-deep in cleaning up the mess.

If you go back to the first chart above you'll note that the 1980s and 1990s witnessed unusually strong gains in the stock market. Until recently, those gains were extended in the 2000s to similarly sky-high heights. The idea that three unusually robust, back-to-back decades of stock market gains were possible, much less assured, was a fairy tale, of course.

Were there any warning signs that the fairy tale was destined to crumble? Absolutely, although timing was always debatable. But the clues were out there and many observers of the capital markets had been pointing them out for years. Most investors ignored the warnings, and thought that was no risk involved. But the proverbial jig is now up. A clear grasp of the obvious, as a result, is now widely circulated among formerly disengaged investors the world over. Some might even go so far as to call that progress, along with a few other choice names.

If we use the widely cited 10% average return for stocks in the long run, one can well imagine that this decade will have to give back some of the above-average returns earned in the 1980s and 1990s. Painful? Yes, but if you were thinking otherwise you were expecting too much based on the historical record.

The good news is that expected returns for U.S. equities look pretty good, at least by historical standards. No, that's not a prediction that 2009 will be a banner year for equities. But after so much carnage, prospective returns in equities are now encouraging. Why? For the same reason that the outlook for equities in early 2007 looked discouraging: valuation.

Comments

[RomanFinancial:]

Death, ignorance, and taxes are all you can be sure of. I suppose however, that the next thing is what to expect for the next decade. I ponder a repositioning of American Hegemony will realign our stock markets at the % level declines of the London Stock Exchange in the 50's. It won't happen overnight, but it will eat at our infastructure like termites until we learn controlling the world has diminishing returns.

Jan 05 01:29 PM

[Jason Rines...:]

The 'jig' was up by June of 2007. Two things tipped me off, the former Fed Chairman Alan Greenspan and the like keeping the suckers in the game with 'chance of recession 25% nonsense and the understanding of the business cycle/leverage/fractio... reserve lending. Me and some other managers ran our own numbers and concluded banking industry was insolvent, chance of recession was 100% and chance of depression 50% in 2008. I did not post the inevitable outcome for glory or self-edification.

I posted often here under my screen name prior to these events. So what did I do about it? As the CEO of a Consumer Healthcare business I worked 16 hour days and pushed management and staff into do or die mode. We built cash reserves and two year contracts due in cash for fall of 2008. We shortened our acquisition goal to summer of 2008 (missed that goal, oil shock of June scared off potential acquirers).

I will say now that many sectors will be ripe for a 5 year buy and hold strategy this year. I like big pharma, higher ed, technology and raw commodities like oil. However, I will avoid buying until the end of Q1 to see what the new Administration and Congressional policies are going to look like, especially Health and Energy. In such events as we have seen, the landscape changes quite a bit.

Also, earnings will remain bad this quarter and when this is reported, I am guessing we will retest November 2008 lows if not break lower. I will not bite into the bear rally we are currently having. I am a long-term business operator and investor who invests in 5 year horizens, I would probably make a lousy day trader. I stick with a forecast we'll see the next Bull market in 2013. In-between, Washington fiscal policy, banking recapitalization, housing bottoming, meaningful job creation etc will continue to create volatility.

Jan 05 01:38 PM

[prudentinve...:]

All things revert to their long-term trendlines, and after two bubbly decades, it should not be surprising to get lower or even negative returns for a decade or more.

Jan 05 02:04 PM

[lindseykk:]

i sold ALL my financials in august 2007.i wanted to sell all my mutual funds ( international,emerging... & p 500 index,tax-managed capital appreciation in vanguard.my husband said no, i went behind his back and sold 20% and put in pa. long term tax free bonds.also sold REIT fund.i am even more concerned then you.have you heard about the cloward-pivens ( two professors from columbia ) who wrote about creating a fabricated financial crisis in order to bring about socialism?same thought as saul alinsky and community organizing.if obama wants to hire 600,000 government workers and george soros ( who got him elected ) just bought indymac with some other old goldman guys i belive america is headed for soro's open society institute.just like in austin power's ( stupid movie ) george will be meanie me and take over the world.just look at what he did and is doing in romania to control the poor and get power over the mines.he also tried to control the ukraine and georgia but did not work out because they turned on him.he is for gay marriage and his organizations have been behind the california ballot,just helped get al franken in,is for secular society ( he is an atheist )all the illegal imigration rally's in california were orchestrated by his groups,etc.the man is anti-israel that is why obama has not commented on gaza and he wants to decriminilize marijauna which obama is talking about now. i think alot of his $$$ comes from drugs and if we go bigtime into afghanistan like obama talked pre-election than that's part of his plan also , to help his drug supply.i know it sounds very far-fetched but also look up franklin marshal davis who obama refers to in dreams of my father as his mentor.he was from chicago, moved to hawai and became friends with obama's grandfather and possibly had an affair with his mother and is obama's real father.the photo of him resembles obama, much more than obama sr.he also was a communist.things are going to get really strange!!!'jig' was up by June of 2007. Two things tipped me off, the former
> Fed Chairman Alan Greenspan and the like keeping the suckers in the
> game with 'chance of recession 25% nonsense and the understanding
> of the business cycle/leverage/fractio... reserve lending. Me and
> some other managers ran our own numbers and concluded banking industry
> was insolvent, chance of recession was 100% and chance of depression
> 50% in 2008. I did not post the inevitable outcome for glory or self-edification.
>
>
> I posted often here under my screen name prior to these events. So
> what did I do about it? As the CEO of a Consumer Healthcare business
> I worked 16 hour days and pushed management and staff into do or
> die mode. We built cash reserves and two year contracts due in cash
> for fall of 2008. We shortened our acquisition goal to summer of
> 2008 (missed that goal, oil shock of June scared off potential acquirers).
>
>
> I will say now that many sectors will be ripe for a 5 year buy and
> hold strategy this year. I like big pharma, higher ed, technology
> and raw commodities like oil. However, I will avoid buying until
> the end of Q1 to see what the new Administration and Congressional
> policies are going to look like, especially Health and Energy. In
> such events as we have seen, the landscape changes quite a bit.
>
>
> Also, earnings will remain bad this quarter and when this is reported,
> I am guessing we will retest November 2008 lows if not break lower.
> I will not bite into the bear rally we are currently having. I am
> a long-term business operator and investor who invests in 5 year
> horizens, I would probably make a lousy day trader. I stick with
> a forecast we'll see the next Bull market in 2013. In-between, Washington
> fiscal policy, banking recapitalization, housing bottoming, meaningful
> job creation etc will continue to create volatility.

Jan 05 02:13 PM

[Larry House:]

Thanks, James, and iThinkBig makes some good points. I am selling into the current rally; I will probably leave some on the table, but I just don't trust any rally now. What has changed? We are in a multi-year correction. No hurry. Much more to be lost here than gained. I too think there will be some good long-term buys over the next few months as hopefully the fog lifts a bit.

Jan 05 02:15 PM

[market ace:]

The markets no longer have much relationship to economics or financial results. It has become a pure gambling hall driven by fear and greed with traders all operating on hair truggers and large highly leveraged traders depending on computer models and numerous charts to make trades, exclusive of real fundamentals. How can the daily change in the price of oil or gold cause wild price swings in related stocks if market participants are not just pure traders that have made the term "investor" become a relic. Anyone that could not see the Greenspan easy credit bubble about to burst and destroy this country must have been blind. Corporations were also able to "fool" investors with so many stock buy backs that artificially propped up stock prices and consistant lies included in gov't statistics seem to have caught many and blind sided them. Thankfully I have always been conservative and cautious so I was prepared for the bust and now am waiting for the ultimate blow out to get back in the market. This first quarter should present real opportunities as the reality of bad corporate earnings, unemployment and fighting debt problems with more debt sinks in.

One of the greates problems facing any investor today is how to determine "real finncial gain". Since currencies fluctuate radically, inflation/deflation quickly alter asset prices in realtion to other assetprices and debt is being monitized it is hard to know if one is winning or losing. However, in the long run inflation will boost asset prices and those not along for the ride will really suffer.

Jan 05 03:46 PM

[GloomBoom.com:]

This is a scary time if you are investing. I can't just put my money in a box somewhere but I have lost confidence. Gold seems to be a safe place for now.

Jan 05 03:58 PM

[Paul Price:]

The bad news is we've experienced a huge hit (down around 50% at the nadir) already.

The good news is- because of that large drop, we could easily see a 50% upmove from the November lows and still be 25% below the October 2007 high point.

Here's the very simple math:

Start at a 100 base,,,,,,,,,,,,100
Drop 50% .........................
Regain 50% .........................

While still 25% below the all-time high of 100
you've recovered 50% from the November low point.

This is not at all out of the question.
Nor is it an upper limit to what might happen.

Stop worrying about statistics and start looking at buying some sxeriously undervalued quality shares that can easily bounce back by 50 - 100% to where they were just 6 - 18 months ago.

Jan 05 04:13 PM

[Ricard:]

One word: Macrobabble.

Jan 05 05:49 PM

[rp fund man...:]

I believe that 2009 will be the best year the stock market will have on record. No more sellers. All professionals, insiders, and those willing to risk will be benefitting from this year. History tells us that the ordinary investor is always late in the game. 2009 will be a comeback year for investment houses. This rally is going to be big. Believe it...now before its too late. Maybe not too late, but too expensive.

Jan 05 08:28 PM

[Moon Kil Woong:]

I'm sitting here watching the SEC squirm answering inane basic Congressional questions. The one point that comes to my mind when thinking about the market mindset is sick. The SEC investigates problems after the fact except when they get big payoffs to settle investigations without any company claiming wrongdoings. Such payments were up over 40% over the last few years.

The SEC is also unsure if it can adequately investigate overseas investments by mutual funds and brokerages. If I could short the SEC I would. I wonder how much unrealized losses companies have overseas. And the odds those will be adequately reflected on the balance sheet are about 0%. The erosion of the financial market's roots are the erosion in confidence that financial disclosures are real and tangible.

Madoff highlights the fact that there is no one at the wheel insuring any financial statement out there and it is unclear if the auditing agencies are capable or willing to do that either. The accounting scandals 10 years ago basicaly showed that often they are complicit in Enron like fraud. So in the end, why should I trust a single financial or insurance companies books? After all, even they don't trust one another. That's why the Fed is risking all the taxpayer's money backing short term bank to bank loans without any Congressional approval.

Congress doesn't want to know anything bad until it's too late to do anything about it. So in summation, the market mindset is fabrication. The government is letting fraud occur under its nose, throwing money around recklessly, and seems blind and ignorant. You can give any graphic about returns but in reality it doesn't much matter if everything is under suspicion.

Bank losses linked to derivatives could go on for a year or a decade. Pyramid schemes and fraud can pop up every 6 months or every month for all the SEC knows or cares. Financial institutions can't go bankrupt forever because they have just converted themselves to banks so they can cleave to the Federal Reserves free money risk-less giveaway.

Fabricated markets, fabricated money, fabricated balance sheets, fabricated blame. Where we should be blaming everyone we instead blame no one. Rather than solve anything we just investigate everything until everyone gives up.

There has been no regulation, banking reform, derivatives reform, SEC reform, or any other form of critically needed reform since the market meltdown began. So no, the market can go up but the mindset that something rotten in Wall Street is going on will not disperse until we actually do something to prevent mass fraud, deception, and lies from ruling our financial system. Bring the derivatives contracts to light. Someone will loose trillions (the company starts with C).

We all pretty much know the truth. How long will we sit shivering under the covers scared of the off-balance sheet derivatives bogeyman and Finnigan the off shore friend of the SEC fraudster? I'd rather see a Frankenstein than know one is somewhere in my dark room.

Gary Ackerman made a good point. No one has yet seen the monthly statements of Madoff. In fact, Madoff turned all his cash to Treasuries and then reported that he didn't need to submit detailed reports to the SEC because it was all cash. And the SEC didn't blink or think. Hey, there seems something wrong with this picture.

A fund manager who doesn't invest any money at all. Did they think he was a bank? lol

Jan 06 12:23 AM

[OldLimey:]

Paul Price: "The bad news is we've experienced a huge hit (down around 50% at the nadir) already.

The good news is- because of that large drop, we could easily see a 50% upmove from the November lows."

I'm struggling with the causality here. What have I missed?

rp fund manager: Fund managers earn more in management fees when their assets under management rise, don't they? Guess you must be planning on having a big Christmas 09 then.

Jan 06 02:11 PM

[donzelion:]

Excellent, and sobering observations - and throwing some cold water on the "oft-cited 10% annual returns" claim is well done.

The fairy tale of three decades of ridiculous growth can only be believed by folks selling products to others... if women entering the work force was the main driver of growth in the 80s, and if technology was the main driver in the 90s, then the main driver of growth in the 00s has been...faith in the power of growth.. Entire industries born to convince people of fairy tales...

Jan 07 07:02 AM