It is a sad fact of financial life, and one well documented, that investors often chase performance. They give up on disappointing asset classes, selling out only after taking substantial losses, in order to buy into more recent winners, too often only after those winners have made a good part of their ultimate gains. It is this well-established historical pattern that points to a coming enthusiasm about equities.
For quite some time now, investors have turned away from stocks. Despite periods of strength, two powerful bear markets, one in the opening years of this century and the other between 2007 and 2009, marred the long-term average performance figures of U.S. equities. Since so many investors draw their perceptions of future possibilities from historical performance calculations, the disappointing returns have raised many doubts about the role of equities in fundamental asset allocations.
The statistical record is striking. After the fabulous gains of the 1990s, when the benchmark S&P 500 equity index averaged returns of over 18% a year, the market crash between 2000 and 2002 dominated the averages calculated for the century’s opening decade. By 2010, the average annual 10-year rate of return registered a loss of almost 1%, which was actually worse than the market’s record during the Great Depression. Though the decade of the 1930s showed an average annual loss of slightly over 1% percent, the country was experiencing a general deflation at the time. On that basis, even the nominal loss amounted to a gain in real purchasing power of about 0.5% a year. But prices climbed during the first 10 years of this century, modestly to be sure but enough to enlarge the nominal average loss in the real purchasing power of equity investors to 3% to 3½% a year.
This record, especially the comparison to the Great Depression, deeply affected perceptions. Retail and institutional investors began to question the role of equities in portfolios. Stocks had been considered the best long-run performance bet for so long, many wondered if that former promise were not always false. Articles, scholarly, thoughtful and otherwise, looked for reasons why past analyses were misplaced and frequently found them or what they supposed were reasons. In the process, the articles reinforced negative perceptions of equities. Such speculation began to dissipate by 2005 and 2006, as the strong market gains since 2002 began to restore the picture of longer-term strength. But the 2008-2009 financial crisis and attendant market reverses revived the anti-equity perceptions with a vengeance. Money flowed out of stocks. Even as the market began its irregular recovery after March 2009, the 10-year average annual record showed losses, sometimes as much as 3.5% a year in nominal terms and even worse in real terms. Money continued to flow out of stocks.
As equity gains have built, this picture has begun to change. Since the market low of March 2009, the S&P 500 index has risen more than 120%. In just the last 12 months, it has risen almost 25%. More important, perhaps, even as the 10-year averages included these gains, they have begun to exclude the great losses of 2000-2002. As of the third quarter this year, the calculation of the 10-year average return has ceased to include the S&P 500’s nearly 25% losses between June and September of 2002. Accordingly, in just the last few months, the 10-year average return for the S&P 500 has risen from a mere 2.9% a year to over 8%, a long-term return that even recent investment discussion dismissed as an impossible relic of a false past.
Of course the great losses of 2000-2002 will remain in the record. But analytical conventions will greatly mute their effect. Investors actually seldom look back that far. Custom accounts only for one-year, three-year, five-year and 10-year performance. If there is any reference to a more distant past, the calculations look at 20- and 30-year blocks of time. On this basis, the powerful gains of the 1990s and 1980s will more than swamp the effects of that ugly period at the start of this century. Looking back over 20 years from the present, for instance, the average annual return on the S&P equals 8.6%. Over 30 years, it equals 11.6%. It is these figures, but especially the most recent 10-year average, that will alter formal analytics and inform investors’ perceptions, carefully calculated or derived intuitively.
As these new calculations gain wider currency, history suggests attitudes toward equities will become more favorable. Funds flows should follow. The change, no doubt, will start gradually and then build as the historical return calculation becomes more commonly known and one investor’s perceptions influence another’s. History suggests that the new flows will carry equities up another leg. Sometimes that additional leg is short-lived. Sometimes it can last for a long while, years in fact. It certainly did in the 1980s and 1990s and even in the middle years of this century’s first decade. Especially since valuations in the market remain attractive, there is every reason to expect that this next leg upward will last. Once those funds flows begin, however, the rally will take on a different character.
Milton Ezrati thanks Lord Abbett Regional Manager Henry Raeburg for suggesting this line of thinking.