Lowered Expectations for the Bulls’ Return

Fundamentally
Lowered Expectations for the Bulls’ Return

By PAUL J. LIM
Published: March 21, 2009

THROUGHOUT the 1980s and ’90s, investors took comfort in knowing that short-term setbacks were just that: short. Back then, it took only about a year and a half, on average, for stocks in a bear market to slide from peak to trough and then climb all the way back.

Jeremy Grantham of the investment firm GMO says a roaring bull market is possible, “but it may still take us 10 years” to return to the previous peak.

But this is a different era. The downturn, which cut the Dow Jones industrial average in half, is already nearly a year and a half old, and despite recent gains there’s no clear sense that the worst is over.

So it’s time for investors to reset their expectations, many market strategists say. At the very least, don’t count on the market normalizing, or “reverting to the mean,” with much speed. And don’t count on the market recouping all its losses for several more years.

Setting aside specific problems now facing the economy — like the credit crisis and the continuing troubles in the housing and financial sectors — the math of recovering from downturns of this magnitude is hard to overcome quickly. James B. Stack, editor of the InvesTech Market Analyst, a newsletter in Whitefish, Mont., studied bear market recoveries since 1929; he found that after the most significant downturns — like this one — it has taken more than seven years for stocks to fully recoup losses.

For example, it took 7.2 years after the start of the bear market in 2000 for stocks to reach a bottom and then to climb back to the 2000 peak. After the bear started growling in 1973, it took 7.5 years to return to the high. And after the 1929 crash, equities didn’t return to their previous peak for another quarter of a century.

The current bear market started on Oct. 9, 2007. Based on the average recoveries of the past, the Dow may not make it all the way back to its peak of 14,164 until late 2014. And some market observers say it could take significantly longer.

But don’t stocks usually bounce aggressively off their lows? And aren’t stocks supposed to perform much better than average after years when they perform much worse than average?

Maybe not. A recent report by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School found that the payoff for investing in stocks following bad years was only slightly better than after good ones.

The report looked at global stock market performance going back to 1910. In five-year periods after the worst years in the market, stocks returned 7.1 percentage points above the prevailing yield on a three-month Treasury bill. Following the best years, stocks gained 6.8 points above cash. The study was part of the 2009 Credit Suisse Global Investment Returns Yearbook.

“Betting on quick mean reversion is a dangerous thing,” Professor Dimson said.

But assume for a moment that the market is due for a big snap-back. Even if that were to occur, stocks would still have a steep mountain to climb.

“We could have a legendary run off the lows, but it may still take us 10 years to get back to our old highs,” said Jeremy Grantham, chairman of the investment management firm GMO.

Historically, bull markets have gained around 38 percent in their first 12 months. That amounts to more than a third of the total gains throughout a typical bull market’s life. Let’s assume that such an initial surge happens this time.

The Dow is trading 7,278. A 38 percent rise would lift the Dow to 10,043. Even assuming a 10 percent annual climb thereafter — a big assumption in tough times — it would take nearly four more years to get back to even. That would bring us to 2013.

Investors who bank on 10-percent-plus returns may be fooling themselves, says Robert D. Arnott, chairman of the investment management firm Research Affiliates. “The folks who are thinking that we could go back to a sustained period of double-digit annual returns for stocks haven’t really studied their history,” he said.

Based on long-term returns of the Standard & Poor’s 500-stock index, including dividends, Mr. Arnott said it was reasonable to expect that stocks might generate annual returns of around 8.5 percent.

IN the 1990s, he noted, earnings growth was higher than average. That, as well as investors’ willingness to pay higher prices for each dollar of earnings, accounted for the outsize market gains in that decade, he said.

But that kind of euphoria about stocks will probably not be repeated anytime soon, as price-to-earnings ratios for stocks have fallen back in line with their historical norms and are well below their recent highs. “We have to move people away from the mind-set that anything less than double-digit returns is disappointing,” Mr. Arnott said.

Here’s another way to think about it: Even if it takes 10 years for the Dow to claw back to its old highs, at an annual rate of nearly 7 percent, “you would have still done very well — certainly better than in T-bills,” Mr. Dimson said.

Single-digit stock returns may not seem all that thrilling, compared with the huge numbers posted during the bull market of the ’90s. But for many investors, a stretch of modest returns might be a great relief after the losses of the last few years.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

http://www.nytimes.com/2009/03/22/your-money/22fund.html?em