March 13, 2003
That Magic 8% ... Or Maybe Not
If I hear one more investment advisor prattle on about "8 percent per year" expected stock market returns, I am going to have a fit.
Oh, what the heck. I'll have a fit now.
Just how in the world do these financial gurus validate this stuff? I mean, I know the answer: The analysts and financial planners and fund managers have gotten that oft-quoted 8% from "historical market data." Eight percent is probably a number that some sort of conglomerated stock market index supposedly returned over a long, long period of time. It probably includes dividends reinvested. It probably includes dropping companies whose poor performance got them yanked from whatever index they were miring down. And it almost certainly takes into account the tremendous bull market that evolved in the early 1980s and carried into 2000. It also almost certainly takes into account the tremendous, rocketship appreciation in the market from the years 1998 to 2000.
News Flash, guys: That sort of market performance ain't normal. It's a once-in-a-lifetime thing. Which to me means that it ain't happening again for a long time.
Sure, bull markets will come around again. But they don't generally hang around for cycles of twenty years. And they don't generally do what the market did (and the Nasdaq in particular) from 1998 to 2000.
Consider, for a moment, the Nikkei. That's Japan's largest stock index. Now, I'm not sure you can draw too many exact parallels between the Nikkei and our NYSE and Nasdaq. Still, where market history is concerned, bubbles are bubbles. And bubbles, in whatever form, have a tendency to work themselves out in similar fashions.
Check out this very long-term chart of the Nikkei. See that huge top back in 1989/1990? By my visual estimation, the Nikkei peaked at a level of somewhere around 36,000. I was just graduating from high school at the time, but I still remember back then that people here in the states were questioning just how it was that Japanese investors could be paying those exorbitant prices for their stocks. Searching for some sort of basis for the seemingly-uninterruptible Nikkei ascent, people in the late 80s talked about how the Japanese culture had perhaps developed a weird sort of "higher tolerance" for excessive stock-prices and valuation premiums. (Meaning the underlying earnings of the Japanese companies didn't merit the valuations investors were slapping on them. Sound familiar?)
So back then, the Nikkei and its valuations − so we Americans said − were just insane.
Apparently someone in Tokyo figured that out in 1989, because that was about when the party was over.
Count up the years between that Nikkei peak and now. That "top of tops" occurred fourteen years ago. Scan over to the right edge of that chart, and what you'll see is a Nikkei that, as of this very moment in 2003, is still making fresh lows. It's now meandering in the Valley of 7,860 or thereabouts.
Keep in mind that those aren't just one-year lows, or five-year lows, or ten-year lows. Those are twenty-year lows.
You don't read about many of those, do you? You don't hear the fund managers on CNBC telling you to prepare for a market that'll be significantly LOWER fifteen years from now. And still lower three years after that. All in all, it's pretty astounding stuff.
And the Nikkei's ride hasn't been just a straight-down plummet, either. Check out that sideways action (the most frustrating action of all ... for traders, at least) from 1992 to 2001. Nine years of that, and you'd think you'd have the makings of a fresh bull market. But nope − still fresh new lows in 2003, reaching back to levels last seen in 1983.
So do you wonder − as I do − whether Japanese investment advisors and financial planners have been spouting to their clients about the merits of "buying and holding" all this time? Have they been espousing growth-stock investments to all the young, upwardly-mobile Japanese thirty-somethings all this time? What "expected percentage return" do you figure they've been reciting ad nauseum to the Japanese investing public for the last twenty years? One thing's for sure:
I bet it wasn't negative.
"Look, this is a great time to be getting in," they were probably saying back in ... oh, I dunno ... pick any year between 1990 and now. "The market's down so far. There are bargains all over the place. It's just a matter of time. Interest rates are so low, money has to go looking for better returns. The stock market has to go up."
No, actually, the market doesn't have to go up, no matter where interest rates are. At some point, you're falling from such heights that you cannot reasonably expect to reverse direction easily. The best you can hope for is some sort of cushion. And that's what low interest rates give you.
Refer again to the Japanese situation, and historical interest rates there. Back in late 1989, the Bank of Japan had pegged its discount interest rate in the 3.75% to 4.25% range. In 1990, probably fearing inflation, they lifted rates twice: up to 5.25% in March of 1990, and then to 6.0% in August, where rates stayed until July of 1991. From that point forward, though, the BOJ acted with a consistent downward bias in its rate adjustments. In September of 1995, the Japanese discount rate touched .50%. In September of 2001, it was resting at .10%. Now, as of January 2003, BOJ discount rates are actually residing in negative territory.
The point is that where stock markets are concerned, low interest rates are a guarantee of nothing.
Besides, as I keep telling friends, where the market's been previously has absolutely nothing to do with whether current prices are worth buying. That's a hugely important factor to understand. You must realize that the U.S. stock markets in 1999 and 2000 were, in fact, in an unsustainable "valuation bubble" of epic proportions. At the end, when everyone and their guardian angel were heavily into tech stocks, it was nothing short of a mania.
Normal bull market cycles and corrections can easily work themselves out in a matter of three or four years. Bubbles don't. In my opinion, whatever "historical market returns" you hear in your company 401(k) meetings can pretty much be thrown out entirely. They have no relevance right now. They also won't do you a palmful of good when you're staring at a list (as I was a few days ago) of forty possible retirement-account mutual funds, many of which are down 25% or more just in the past year. (I bet the two previous years weren't happy ones, either.)
How many years of that expected 8% return is it going to take to overcome three straight years of 30% losses? After three bend-over-and-grab-the-counter years like that, a $10,000 retirement account would be worth $4,019.
But let's be optimists. Say that was it for the bear market − no more downside after that three-year mark. In fact, from there, give your remaining $4,019 investment Wall Street's Magic 8% Return per year. You'd be back up to $7,600 in a mere eight years.
Big deal, you might think. Eight years is nothing. Right ... but that's eight years of investment, and you're still $2,400 in the red. Give it three-and-a-half more years after that, and you'd finally be back to just over $10,000.
So that's almost twelve straight years of 8% returns just to recoup what you'd lost in three. Twelve years just to get you back to even.
Suddenly the 3% guaranteed yield of treasury bonds sounds pretty comforting, huh? Especially when compared how far behind those 25%-per-year losses put you.
Now refer back to the Nikkei chart again. We're now fourteen years beyond the top. Fourteen years, and where exactly do you see returns of 8% per year happening in there? Right. I don't either. So if you're in the Nikkei, and your $4,019 (again, let's say that's what's left of your initial $10,000 investment from way back when) is still invested in stocks, then with that hypothetical 8% per year return from this point on, you'd be looking at a total of almost 26 years just to break even.
That, friends, is the preeminent danger of being in the market at the wrong time ... and letting it ride.
(Which brings me to another interesting point: I notice that this investment-return calculator at Bankrate.com uses an assumed "large cap stock" return of 11.3% per year when you plug in your investment amount. This percentage, it says, reflects "...average asset class annual returns, 1926-1999 (source: Ibbotson Associates)." Good luck finding annual returns like that for the next twenty or thirty years, says I. If these really are people's expectations, then they're in for a painful study in stock-market reality.)
An even worse problem: Many analysts are fond of relying on 12 percent returns from stock-market investments (mutual funds, etc.) when they perform their investment calculations. This, they often say, is the "market's historical average," over time periods as long as 70 years. I'm not certain how many of their clients are looking at investment horizons of 70 years, though. Honestly, investors would benefit more by knowing and/or using returns from, say, the worst of any 20-year period over the last 70 years or so, or perhaps the average of all 20-year periods over the last 70 years. Most websites place these rates at anywhere from 7.9 to 10 percent return annualized. Still, these computations usually consider only the post-WWII period (1946-1950) up through 2000. Doing so still slants the number's in the market's favor, as it takes into account the 1990s hyperbolic market rise and disregards the collapse of the latter 1920s and 1930s and that of 2000 through 2003. Even with the above returns, no mention is made of the effects of inflation (3 to 4 percent per year, generally), taxes, or commissions / management fees, which would reduce the real returns even further. According to the graph on this SmartMoney page, the worst return from any 20-year period in the span from 1950 through 2002 (large cap stocks; adjusted for inflation) was very near zero; the average return for 20-year periods in this time frame was around 6 percent annualized; and the best return from any 20-year period in this time frame was near 13 percent annualized. (These figures still do not account for commissions or management fees, which would likely lop off another 1 to 2 percent from the returns.) So analysts are using figures that most likely reflect the best possible annualized returns one might hope to achieve over a 20-year time frame. Exactly how reasonable is that?
In my humble opinion, the best that folks can honestly hope for out of the American stock markets, long-term (say, ten years or more) from this point, is sideways action. I'm talking a big-picture view here: Perhaps some rise from these levels, then generally sideways action for maybe eight years ... maybe ten years ... or maybe much longer. And that is my best case scenario. What happened to the Nikkei (20 years of either sideways or gradually declining values) could happen here, too − mostly because people seem to think that it can't. Never discount the ability of a market to do precisely what the masses think it cannot.
The simple fact is that if you (1) knew what you were doing, or (2) got really lucky, then lifetimes of money were made as the bull market of 1980-2000 roared upward. (Heck, lifetimes of money were made in just the period from 1998 to 2000.) Unfortunately, lifetimes of money will be lost as the ensuing cyclical bear market corrects prices back to ... well, wherever they end up. It will correct prices, and it'll correct them fully.
With all this, really, I'm not attempting to rain on anyone's parade.
I just think it's worth considering that somewhere down the road, rain or not, the parade might not end up on the side of town that all the "experts" say it will.
March 13, 2003
Play Great Defense