The New Normal.

By now, you have probably read that you should prepare yourself for a New Normal in the stock market. The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. And by now, many are accepting the talk about a “new normal” in which stocks offer lower returns in the future.

The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.

Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:

1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.

US Stock Market Performance after 1932*
Annualized
5 Years: 15.35% – Growth of $1: $2.04
10 Years: 10.07% – Growth of $1: $2.61
20 Years: 13.19% – Growth of $1: $11.92

All stock market returns based on CRSP 1-10 index.

*Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.

US Stock Market Performance after 1941*
Annualized
5 Years: 18.63% – Growth of $1: $2.35
10 Years: 16.67% – Growth of $1: $4.67
20 Years: 16.29% – Growth of $1: $20.47

1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.

US Stock Market Performance after 1974*
Annualized
5 Years: 17.29% – Growth of $1: $2.22
10 Years: 15.92% – Growth of $1: $4.38
20 Years: 14.89% – Growth of $1: $16.07
5 Years 10 Years 20 Years

1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.

US Stock Market Performance after 1981*
Annualized
5 Years: 18.82% – Growth of $1: $2.37
10 Years: 16.58% – Growth of $1: $4.64
20 Years: 14.54% – Growth of $1: $15.11

1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.

US Stock Market Performance after 1987*
Annualized
5 Years: 16.16% – Growth of $1: $2.11
10 Years: 17.75% – Growth of $1: $5.12
20 Years: 11.89% – Growth of $1: $9.46

2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”

US Stock Market Performance after 2002*
Annualized
5 Years: 13.84% – Growth of $1: $1.91
10 Years: - – Growth of $1: -
20 Years: – - Growth of $1: -

2008–Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.

Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?

Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.

What’s new about that?

Human emotion is an important factor in successful investing.

Would it surprise you to know that the worst stocks during the bear market that ran from October 9, 2007 to March 9, 2009 turned out to be–by far–the best performing stocks over the next 12 months?

Bespoke Investment Group did an interesting study where they took the S&P 500 stocks and ranked them from 1 to 500 with 1 being the worst performer and 500 being the best performer during the October 9, 2007 to March 9, 2009 bear market. Then, they sliced this ranking into deciles, with decile 1 being the 50 worst performers, decile 2 the next 50 worst performers all the way to decile 10, which were the 50 best performers.

They discovered that decile 1 (the 50 worst performing stocks during the bear market) turned around and rose, on average, 371% during the next 12 months that ended March 9, 2010. Decile 2, the next 50 worst performers, rose 184% over the ensuing 12 months. By contrast, decile 10, the 50 best performing stocks during the bear market, only rose 30% over the following 12 months. Essentially, the worst stocks during the bear market performed the best during the bull market and vice versa.

The study also showed that the average change of all stocks in the S&P 500 was 122% over the 12 months following the March 9, 2009 low.

This study points out one reason why understanding human emotion is an important factor in successful investing.

Think of it this way: on March 9, 2009, at the bear market low, would you have been enthusiastic about buying stocks that had declined 80-90% over the previous 17 months? Probably not because your emotions would have been so rattled, yet, those were the types of stocks that turned out to be the best performers over the next 12 months, according to Bespoke Investment Group.

As the last few years have shown, successful investing sometimes requires that you gather your courage and do what seems most frightening because the point of maximum “frightening” may also be the point of maximum profit potential.

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With the dawn of a new decade arrives the financial media’s recommended investments.

Articles with attention grabbing titles such as “10 Stock Investments for the Next Ten Years” entice readers with promises of market beating returns.

But should you follow media’s investment recommendations? Consider the following articles published ten years ago.

In August, 2000, a Fortune magazine article presented “10 Stocks to Last The Decade.”

How would these ten stocks have performed if you spread your investments equally among each pick versus the market and a fully diversified portfolio*?

• Fortune’s 10 Stock Investments:  -44.21%
• S&P 500:  -7.26%
• Diversified Portfolio: +81.04%

Time period – August, 2000 through November, 2009.

Fortune’s stock picks drastically underperformed both the market and a fully diversified portfolio.

A second article by The New York Times asked for Buy and Hold picks from “10 very smart, very successful investment professionals…”

So how did these stock picks fair versus the market and a fully diversified portfolio?

• New York Times:  +25.17%
• S&P 500: -4.29%
• Diversified Portfolio:  +84.35%

Time period – February, 2000 through November, 2009

The New York Time’s picks beat the market but it seems a passively managed diversified portfolio drastically outperformed these “very smart, very successful investment professionals…”

Think twice before rushing out and investing your money in any of the media’s picks for the next ten years!

Having a financial plan and a fully diversified portfolio based on this plan is the best bet when investing for your goals and future.

*Fully Diversified Portfolio:
Dimensional US Adjusted Market 2 Index: 30%
DFA Equally Weighted Emerging Markets Index: 5%
Five-Year US Treasury Notes: 40%
Dimensional International Market Index: 25%
Rebalanced annually

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This question has been coming up a lot lately in the media and some academic journals. Thinking Modern Portfolio Theory died last year is based on the misconception that Modern Portfolio Theory will guarantee against a loss.

That is simply not the case. What MPT believes is diversification to a portfolio, which over the long term can potentially reduce a portfolio’s volatility versus a single asset portfolio.

According to a recent article in Investment News:

• MPT does not guarantee against a loss
• Fixed income helped reduce the amount of loss in many portfolios last year
• Many advisors are finding that their clients had too much equities and not enough fixed income for their risk tolerance

Remember, when investing in a diversified portfolio, you will experience negative returns periodically.

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