As most equity markets touch new lows for this cycle, it is worth seeking some historical perspective because retaining a cool head while the crowd panics usually proves very profitable. Although the US stock market returned 10-11% per annum over the last century, we had three identifiable 35 year cycles, incorporating 17 years of 18%-20% average annual returns along with 18 years of 2%-4% average returns. The riskiest time to buy equities was a decade ago, when normalized earnings were at their highest since 1929 at nearly 30x, and yet the professional consensus was unrelentingly bullish. We've been in a grinding valuation mean reversion ever since. Even the trough in 2003 was at the highest ever valuation level for a bear market low. While I have preferred TIPS, real assets and investment grade corporate bonds, equities are now at their cheapest versus bonds since 1932, and on a cyclically adjusted basis are trading well below their long-term average multiple. Buying a blue chip portfolio today, even if the S&P bottoms ultimately at something like 600, should earn high single digit compound returns over the next decade on very conservative economic forecasts.
It always feels awful as markets grind through the bottoming process as they are now. Take the last bear market low in 1981-82. Back then, the media consensus was that equity investing was a losers game and capitalism was on the brink, as magazine covers from the era attest. Stock prices had just suffered a 16-year slump as the S&P 500 went nowhere from 1966 to 1982 in nominal terms (ie declined dramatically adjusted for inflation). Short-term interest rates under the Volcker Fed peaked at 20% in June 1981 and that in hindsight marked the bear market bottom. An investor who bought the S&P 500 Index in 1982 would have made 11.1x their money in nominal terms or 6.5x in real (inflation adjusted) terms by December 1999 (when this secular bear market began). Or take, the vicious 1973-74 bear market; by December 1974, the S&P 500 Index had collapsed a cumulative 50% from a peak in January 1973.
To buy at the time you had to ignore headlines such as war in Vietnam and the Middle East, a plunging dollar, soaring commodities and rising inflation. That took big cojones. The economy went into a nosedive starting in 1973 and remained in the doldrums for years. Despite this, an investor who bought the S&P 500 Index in late 1974 at the bear market low of 61 would have gained 50% 12 months later as the market recovered. And from the bear market low of 60.96 in late 1974 that same investor would have gained a cumulative 264%, excluding dividends, by 1980. The greatest bear market rally occurred from 1929 to 1932 when the broader market crashed almost 90% until bottoming in mid-1932. From its low in June 1932, the market thereafter surged more than 350% until crashing again in 1937.
Still, an investor who bought stocks in 1932, 1933 or 1934 would not have lost money until stocks finally bottomed in 1942 in the middle of a World War; the absolute low for the cycle was June 1932. History confirms that buying stocks in the midst of economic crises can indeed pay-off even over a short period of time such as occurred in 1932, 1974 and 1981. Stocks overall remain high-risk as a buy and hold at this stage of the economic cycle, and corporate bonds are a safer each-way bet. I expect a near-term rally through March and possibly into April, followed by another deep reversal to new lows around 600 on the S&P. Timing is everything, and better to invest at in the latter stages of a generational bear market, than at the end of a bull one, even though the latter fells far more intuitively comfortable. In any scenario, your return as a buy and hold investor will depend crucially on the normalized long-term valuation when you enter, changes in economic conditions after you enter, what income stream you receive from your investments, what time value losses you incur, and what inflation related purchasing power losses you incur.
The chart above from economist John Husmann is the best I could find to frame the opportunity in broad economic terms; the red line (scaled on the left axis) shows the earnings yield of the S&P 500. It uses peak earnings and it's lagged by 6 months; the recent stock market decline has pushed the earnings yield above 10 percent. This is a very attractive earnings yield relative to the last 25 years, but not as attractive as levels reached at the market bottoms of 1974 and 1982. The blue line attempts to capture the expectations of investors for economic variability based on the recent past. It sums the percent of time the US economy was in recession over the prior decade and the current rate of inflation. With near-zero inflation, it's currently about 20. Current levels of valuation look attractive when compared with the current sum of the percent of the previous decade the economy was in recession and the CPI ie adjusting for periods of economic volatility (which obviosuly will negatively impact investor returns). The market bottoms of 1974 and the early 1980's discussed above coincided with a large percentage of the previous decade in recession and high inflation.
In summary, the bear market that began almost a decade ago may well last until the 2012-2014 timeframe, but we will probably not see the lows of this year again in this cycle. In other words, by the end of 2009 investors will have seen the the greatest long-term stock market buying opportunity in at least a generation. Equities are a distressed asset class right now, and the best time to buy those is when the news is unrelentingly bearish.
