Bull or Bear? Let History Be the Guide

Sometimes it is helpful to look at history. In evaluating what might be in store for the U.S. stock market, this is one of those times. I have selected the DJIA (Dow Jones Industrial Average) for analysis because data is available from before 1900.

The graph below shows the 10-year and 20-year moving averages for annual returns (without dividends) for the DJIA.

Since 1950 the 20 year moving average has trailed the 10 year moving average very consistently. The average trailing time is 3-5 years except near extreme highs and lows where the two are more nearly coincident.

Before 1950 the two moving averages spent more than three times as long below the 107 year compounded average return of 5.3% than above. Since 1950 the 10 year moving average has been above the 5.3% average return for 41 years and 17 years below. This is almost the reverse of the first half of the twentieth century. From 1950 to 1965 we spent 16 years above the average; in 1966 and 1967 the 10 year moving average oscillated below and above the average; from 1968 to 1983 we spent 16 years below the average. From 1984 to 2007 the 10 year moving average has spent 24 years above the 5.3% level. Do we have a long period (say 24 years) with the 10 year moving average below the long-term 5.3% average annual return? If so, the coming years could look something the 1970’s for U.S. stocks. In the 1974 to 1982 period, there were six years with the 10 year moving average return was near zero or negative. There were only two years above zero with low single digit 10 year average returns.

A similar discussion can be held for the 20 year moving average with similar conclusions. A reversion to the mean for behavior of U.S. stocks would argue that for 2008 to 2065 we should reverse the behavior of 1950-2007 and spend more years with the 10 year moving average below 5.3% than above.

Although it is not plotted, the trend line for the 10 year moving average return has an upward slope for DJIA returns from 1900 through 2007. If that were to continue, projected returns would improve marginally over the next 57 years, but would not change the argument that reversion to the mean (now an upwardly sloping trend line) would produce below average returns for many years forward. Using this trend line rather than a level 107 year average would require that one accept that there are reasons why the average annual return trend line should continue the upward slope in the future. It is hard to argue that there are fundamentals to support this supposition.

Bottom line: be prepared for an extended period of many years with average annual returns that are less than 5%, with more than a few years of negative returns. There is an old saying: “Those that do not learn from history are doomed to repeat it.” Enjoy the good years, but the patterns of history indicate there are fewer good years coming than we have seen in the second half of the twentieth century.

Comments

[gon4beer:]

For another (and more informative) take on this subject, check out the free August 2008 report on contraryinvestor.com-v... scary reading. For the record I have no connection to the website other than as an interested reader.

2008 Aug 13 08:31 AM

[User 59050:]

thank you for a most interesting article.

2008 Aug 13 08:43 AM

[Paul Killinger:]

Great post!

For those that believe we've somehow entered a "new" investment world, they forget a lot more SCARY stuff has occurred during the past century than what we're witnessing today.

2008 Aug 13 11:59 AM

[Rolling Wave:]

The fundamental driver of the exceptional post WWII growth was the increasing demand of these emerging consumer class in the US, Europe and Japan - about a billion people. The uneven growth of the first half of the last century lacked that economic driver, and secure base to generate growth.

1900-50 is not comparable 2000 to 2050 - the latter period will have roughly 2 billion new consumers in China/India and elsewhere in Asia embracing and joining the middle class in real terms. In the big picture, the effective global market will triple the billion consumers that the US, Europe and Japan let loose from 1945-50 to drive the growth of the past half century. This new surge will provide, with the inevitable bumps and mistakes (from governments to greed and corruption) an engine of growth that will pressure commodity prices (current 15 year uptick), then new tech goods and services to new levels of growth.

Only issue is whether US will continue to embrace global opportunities this represents, or let small interest groups (like the million US farmers which scewered the Doha trade round two weks ago) protect their comfortable and uncompetitive monopolies and subsidies. It was US business which led the charge to globalization since 1950, with huge benefits for American prosperity and consumers. Only question is whether US business will continue to exploit these emerging market growth opportunities.

My conclusion argues against the article - that average growth can stay above the 50 year trend, if American business seizes their share of future growth....my bet is yes, regardless of the initial hesitation about the adjustment pressures this will foce on the old economy players, and the bumpiness of the ride.

2008 Aug 13 12:27 PM

[John Lounsbury:]

Craig74 - - -

Great comments. I agree that opportunity abounds PROVIDED that the U.S. economy responds properly to the challenges. First among these is an energy revolution which dwarfs all other economic issues. I wrote a previous article discussing this.

The rising consumer class in Asia may or may not produce significant benefit to the U.S. market. Yes, multinationals such as McDonalds, for example, may participate. However, Asian firms may get much more of the growth than U.S. corporations. The BRIC markets may far outperform the U.S. stock market.

I am reminded that in the 1980's Japan was deemed destined to rule the world, just as China is now. The difference now is that the demographics of China are much different than those of Japan and a similar fate for the Chinese economy (compared to Japan of the past 20 years) is not likely.

Going back to the 1900-1950 era, that was a period of dramatic manufacturing (and research and development) growth, led by the U.S. With the exception of opportunity in the coming energy revolution, the U.S. does not have the same scenario available for the first half of the 21st century. If there is to be a similar economic performance, it will be led by China and India.

Finally, one recipe for having U.S. stock markets in the first half of the 21st century revert to a form similar to the first half of the 20th century is: (1) keep buying energy from abroad; (2) keep trying to get rich by buying and selling houses to each other; (3) depend on financial services to be a growth engine to the exclusion of production of goods; (4) allow medical services to continue at a level of 16% of GDP (I believe that is where it is now).

Others might add some more ingredients to the recipe, but my list is a decent start.

2008 Aug 13 02:18 PM