Market Review for Q4 2009

Includes: DIA, SPY
by: John D. Frankola

The year ended on a strong note, with the S&P 500 Index advancing 6.0% in the fourth quarter. Since the current rally began in March, the S&P 500 has recovered about half of its total bear market loss. The S&P 500, which peaked in at 1565 in October 2007 and bottomed at 677 in March 2009, closed the year at 1115. While the 26.5% returns in 2009 are encouraging, the S&P 500 currently stands 28.8% below its all-time high. As noted in the table below, the S&P 500 has produced an average annual loss of 1.0% for the past 10 years – making it the worst calendar decade on record for the index.

Despite a strong 2009 performance, the following table illustrates that the major stock market indices have produced total returns for the 3, 5, and 10-year periods that are significantly below the long-term annual average of 9.3%.

Last year's stellar performance reflected a recovery from an economic crisis and a market panic. While the U.S. economy sunk into recession, its severity was nowhere near the collapse of the Great Depression. Real gross domestic product (GDP) fell less than 4% from the beginning of the recession in late 2007 to its low point in the second quarter of 2009. This contraction was similar to recessions of the 1970s and 1980s, but had no resemblance to the Great Depression which experienced a more than 25% GDP decline and a 25% unemployment rate.

Although the recent economic decline was far less severe, the related stock market collapse came close to matching that of the Great Depression. What caused the panic? Probably foremost was the fear of a total meltdown of the global financial system. But also, it didn't help that noted media pundits fueled the fears of the investing public. For example, CNBC celebrity analyst, Jim Cramer, told the NBC Today show audience on October 6, 2008,

Whatever money you may need for the next five years, please take it out of the stock market right now, this week. I do not believe that you should risk those assets in the stock market right now.

On January 5, 2009, Nobel Prize winning economist, Paul Krugman, wrote in aNew York Times op-ed column , "Let's not mince words: This looks an awful lot like the beginning of a second Great Depression." Unfortunately, many investors heeded those words, and sold at or near the market's bottom in the midst of the panic.

Though there has been no official declaration that the recession has ended, most economic indicators signal that the economy has been improving since the middle of 2009. GDP increased by 2.2% in the third quarter and is expected to show a strong improvement in the fourth quarter. Corporate earnings have been stronger than expected in both of the last two quarters, house prices have increased for five consecutive months, retails sales have rebounded, and consumer sentiment is moving higher. Both companies and individuals have improved their balance sheets over the past year by cutting spending and paying down debt. The financial sector is on much firmer footing, as demonstrated by the repayment of TARP funds. Of the $331 billion invested to support financial companies, $147 billion has been returned. The emerging markets, such as China, India and Brazil have resumed strong growth. For example, in November China's industrial production rose 19.2% and retail sales increased 15.8%. U.S. companies that export or have foreign operations have benefited from exposure to these markets.

Of course, a number of significant problems still exist. Unemployment remains stubbornly high, which could a limit a rebound in consumer spending. While financial firms are in better shape, there are still worries over possible further erosion in the housing market and problems with commercial real estate. Perhaps the biggest concern relates to the uncertainty over government intervention into the economy. How effective is the current stimulus program and will the economy fall back into recession as stimulus spending is curtailed? Can the government unwind its support of the financial system without a disruption to the markets? Can the current budget deficit be reduced? How will proposed healthcare reform impact the economy? Will taxes be increased? The resolution of these questions will have a major impact on the market.

With most other classes of investments producing large losses and high volatility in 2008 and early 2009, investors poured money into Treasury investments in an attempt to avoid risk. Ironically,the 10-year Treasury bond produced an 11.1% loss in 2009 as its yield rose from 2.2% at the beginning of the year to 3.8% at year end. With the possibility of further record issuance of Treasury securities to support deficit spending and higher overall interest rates as the economy improves, Treasury securities do not appear to be attractive. Most other types of fixed income investments had positive returns in 2009, benefiting from an improved economic outlook for issuers.

Considering that stocks have produced losses for the past decade, many investors now question whether they are appropriate investments for meeting long-term goals - and if they are, what return expectations should be used for investment planning. Since 1927, stocks (as measured by the S&P 500 Index) have generated annual average returns of 9.3%. This compares to 5.0% for 10-year Treasury bonds, 3.7% for 3-month Treasury bills, and 3.2% for inflation. As shown in the adjacent chart, over the long-term, stocks have been more effective in creating wealth than any other financial asset class.Looking ahead, I believe a 10% return estimate for equities is still appropriate for long-term investment planning.

Rather than negatively impacting my forecast, the performance of the past decade leads me to conclude that returns over the next decade can be at or above historic levels as the economy recovers and the current problems are rectified.Throughout its history, stock market returns have had a tendency to revert to the mean (or average). Indeed, this phenomenon has occurred over the past two calendar decades. The 1990s, which were the best decade on record with 18.1% average annual returns, were followed by the worst decade. Numerous other examples of this pattern exist. If one looks at each year since 1927 that experienced below-average returns, the following year had average returns of 14.2% - significantly above the long-term average of 9.3%. For all 10-year periods with below-average returns, the following 10-year periods averaged 14.4%.

For investors who are frustrated because that they have diligently saved for the last ten years and have very little to show for it, they might eventually look back at the 2000s as a window of opportunity. Patient investors who were able to add to their stock investments during past extended market downturns have been rewarded in future periods. Despite the current concerns facing the market, there also appears to be many reasons for optimism about the future.

Disclosure - No individual stocks mentioned