We’ve been taught that long-term investing in the stock market will provide market returns above inflation. For large periods of history, this simply has not been true.
If we look from 1929 onward, the Dow Jones Industrial Average returned about 9% annually, including dividends. Thus, if we invested $842 in 1929, it would have become $1,000,000 in 2010. Likewise, an investment of $18,678 in 1970 would have become $1,000,000 in 2010. But what’s really behind this growth pattern? Using a compound growth calculator for the Dow, we can take a closer look at stock market returns. Clearly, the rise has been all but a straight line, with much of the growth coming during a relatively brief 30-year period.
And that growth is only half of the story. To measure the true purchasing power of our investments, we need to compare it to inflation. "Truth about inflation" (below) includes monthly consumer price index (CPI) data provided by the Department of Labor Statistics. However, the CPI has been recalculated over the years for both economic and, some would say, political ends. The chart also includes an alternate CPI measure calculated by ShadowStats.com (SGS). The alternate CPI is an attempt to correct for methodological changes to the standard CPI over the decades.
The difference is striking. According to the CPI, $1 in purchasing power in 1970 would require $5.80 now. According to the alternate CPI, it would require $20.92 now. During 1970-2000, $1 in the Dow would become $53.54, with more than 35% of that being dividends. More recently, the situation isn’t so rosy. Using the standard CPI, January 2000’s $1 of purchasing power would require $1.34 now and $2.86 using the alternate CPI. Stocks? They returned only 1.36% over this period—around the official rate of inflation but less than half the real rate.
For those recently retired, consider yourselves lucky. Most likely, your portfolio benefited greatly from the extraordinary 1970-2000 period. For those a decade or more away, the prospect of a 15- to 20-year period of sideways returns should be a wake up call. Buy and hold won’t cut it. We will attempt to find out what will by taking a closer look at some of history’s more significant bear markets. Through them, we will form the premises that will be the foundation of a modern systematic solution to long-term active investing.
Crash of 1929
During the 1920s, the stock market was a good investment, and by 1928, it was in full bloom. By then, Americans of all social backgrounds began accessing the stock market. Many started buying stocks on margin, with as little as 10% down.
On Sept. 3, 1929, the stock market peaked with the Dow closing at 381.17. After two days, the market started to fall, though not steeply at first. Stock prices oscillated through September and October until Oct. 24 before a slight rally prior to Oct. 28. This shocked speculators into another selling spree, banks did nothing to stem the panic, and the Oct. 29 crash was the result. Prices fell, and a steady slump set in for two years. On July 8, 1932, the Dow closed at 41.22, the market’s low point.
The economy was wrecked, companies were ruined, life savings were gone, and faith in banks was destroyed. The Great Depression, worsened by slack monetary policies and the subsequent misappropriation of capital based on cheap money, was well on its way.
In 1929-1933, U.S. gross domestic product (GDP) declined by 33%, general unemployment rose to 25% and industrial unemployment rose to 35%. After the 1932 election, President
Franklin D. Roosevelt’s unprecedented recovery plan, The New Deal, ushered in reforms, relief and recovery. A slow but brief upturn set in through 1937, when weakness returned and unemployment rose, sparked by higher taxes and the Federal Reserve reducing the money supply in 1936-37. The economy did not recover to pre-Depression levels until the onset of World War II.
Crash of 1987
The first half of 1987 witnessed a sharp decline in the U.S. dollar and a subsequent increase in U.S. exports, which provided extra earnings to the companies and gave stocks a boost. Corporate restructuring and promises of strong growth further bolstered expectations and prices. The foreign investment rate doubled from 1986 to 1987 and in August alone, the Dow increased by 41% (800 points).
In September 1987, rising interest rates and the continually weak dollar worried investors. Volatility in the markets surged. On Sept. 22, the Dow had a record single-day gain. On Oct. 6, it suffered a record single-day loss. Then, on Oct. 19 — Black Monday — the stock market sank quickly. Volume and volatility spread through the futures market as stock buyers dried up. Program trading and portfolio insurance made the situation worse, with automated systems swamping the market with sell orders. The Dow fell by 508 points (22%), causing losses of more than $500 billion.
Numerous regulations emerged from subsequent investigations. The Securities and Exchange Commission (SEC) issued a number of changes; the technological infrastructure of the stock markets was upgraded; margin requirements were modified; circuit breakers that would stop trading following a specified drop were implemented.
After the ‘87 crash, the market recovered amazingly, rising slowly and steadily with the Dow recording a new high before the end of 1989. This recovery was credited to strong market fundamentals and timely action by the Federal Reserve to boost the international faith in the U.S. economy.
The dot-com bubble
The 2000-02 bear market can be traced to the economic growth following the 1991 recession. Among the keys to the Clinton era were moving U.S. borrowing to the shorter end of the yield curve, which reduced borrowing costs and long-term rates. Additionally, President Bill Clinton’s open trade policies fueled economic growth.
On Feb. 17, 1993, Clinton revealed a budget plan that included lower deficits and tax increases. It was the largest deficit-cutting proposal in history, cutting $500 billion in four years. The budget was under control, and the dollar strengthened. Oil prices collapsed. Moreover, the North American Free Trade Agreement lowered tariffs on exports and imports. While we could argue the current loss of U.S. jobs was sparked by the effects of free trade, in the early days it served as a boost.
However, the biggest reason for the growth in the 1990s was the birth of the Internet. CompuServe, America Online and Prodigy were the early leaders. By 1996, 45 million people were online. This grew to 150 million by 1999. The growth in productivity was only part of the story. The bigger factor was the rampant speculation in the companies promising to lead the country into this brave, new frontier.
SEC records include 700+ failed e-commerce corporations. Surprisingly, more than 80% of the SEC listings were headed by dedicated, qualified and diligent managers. More than 90% of them got initial public offering funds, meaning the market considered their models credible.
The crash happened because investment vastly outpaced client acquisition, which came at exceptionally high cost. The public was slow to accept online shopping and found it confusing. In retrospect, this reluctance was not new. For example, despite being available since the mid-1970s, automated teller machines still only had a 50% use rate by the late 1980s. Despite great promises, the early investment rate in dot-com companies simply could not wait for demand to materialize. It didn’t help matters that these same companies emphasized brand awareness and neglected product/service strategies that actually create a market and serve customers.
Following the initial bursting of the dot-com bubble — further accelerated by the Fed increasing interest rates six times in 1999-2000 — the stock market had recovered by the time George W. Bush was elected. The Dow peaked at 11,723 on Jan. 14, 2000, and the Nasdaq hit 5,048 on March 10, 2000. Then, however, came the 9/11 terrorist attacks in 2011 and the economy sank into a deep recession. The market hit its low on Oct. 9, 2002, with the Dow at 7,286 and the Nasdaq at 1,114.
Banking crisis of 2008-09
The roots of the 2008 banking crisis can be traced to the 2000-02 recession and the market weakness caused by 9/11. The Fed undid its earlier interest rate hikes, creating an environment of easy credit and causing a surge in U.S. sub-prime mortgages.
The rest of the perfect storm came together in destructive fashion.
In 2003, the Fed dropped interest rates to 1%, the lowest in 45 years. In August, the Bank of International Settlements (BIS) warned that collateral debts in the U.S. were being ignored. In September, the Bush administration suggested that Fannie Mae and Freddie Mac be supervised under a new agency within the Department of the Treasury. Private enterprise flooded the mortgage bond markets once dominated by Freddie Mac, increasing sub-prime mortgages by 292%. Rather than attempting to rein in the lending industry, the Fed emphasized the ability of lenders to repackage and securitize mortgages.
In 2004, U.S. home ownership peaked at 69.2%. The largest U.S. mortgage lender, Countrywide Financial, in effect dropped all lending standards. Other lenders followed suit. By 2007, automated underwriting accounted for 40% of sub-prime loans. Fannie’s and Freddie’s purchases of sub-prime-backed loans in 2004-06 were $434 billion vs. $175 billion in 2004. Financial institutions started investing heavily in mortgage-backed securities, betting on further increases in housing prices and buyers honoring their mortgage payments.
In 2005, market warnings increased. The head collateralized debt obligation (CDO) trader at Deutsche Bank, declared the CDO market a Ponzi scheme. Robert Schiller warned of the impending housing bubble and the consequences of a global recession. The BIS issued warnings regarding the credibility of credit rating agencies. In June, at Lehman Brothers, traders attempted to back out of the mortgage market by shorting; they were subsequently fired.
In 2006, Commerzbank ceased its huge sub-prime position growth. AIG stopped the sale of credit protection against CDOs. Sub-prime lender Ameriquest cut down on jobs and infrastructure. Merit Financial, based in Washington, filed for bankruptcy. Magnetar created CDOs that failed on purpose to profit on the insurance against their failure. In December, Goldman stated it had reduced bets against housing market.
In 2007, with many major firms having shown their hands, existing home sales plunged. The sub-prime mortgage industry crashed, resulting in a deluge of foreclosures (double of 2006). Subprime giants New Century, Horton, Countrywide and Home Lenders went bankrupt. The Fed pumped $100 billion into the economy for banks to borrow at a low rate. Many long/short hedge funds had unprecedented losses because of liquidations. Internet banking pioneer NetBank went bankrupt. Swiss bank UBS declared losses of $690 million in the third quarter. In October Merrill Lynch revised losses to $8.4 billion from $5.5 billion. Despite all of this, on July 19, the Dow closed above 14,000, a first in its history.
In 2008, we learned that 2007 had the steepest drop in home sales in 25 years. From March through June, an FBI sting arrested 406 people for mortgage fraud. By March 10, the Dow had dropped precipitously, more than 20% off its peak five months earlier. JP Morgan bought Bear Stearns for $10 a share with the Fed backing Bear’s toxic holdings (JP Morgan initially was to pay $2 before and have no exposure to its toxic debt). On Sept. 7, Fannie and Freddie were nationalized. On Sept. 14, Bank of America bought Merrill Lynch. On Sept. 15, Lehman Bros. applied for bankruptcy protection. On Sept. 18-19, Treasury Secretary Paulson and Fed Chairman Bernanke suggested a $700 billion emergency bailout purchase of toxic assets. The Federal Deposit Insurance Corp. detained Washington Mutual and sold its assets to MorganChase for $1.9 billion. Citigroup acquired Wachovia. The week of Oct. 6-10 was the stock market’s worst week in 75 years. The Dow lost 22.1%, down 40.3% from its record high. The U.S. government rescued Citigroup with $20 billion, after a 60% stock price drop the previous week. On Nov. 25, the Fed made available $800 billion to boost the economy and $600 billion to purchase mortgage bonds backed by Fannie, Freddie and the Federal Home Loan Banks.
The market continued to fall until March 2009. It then began a rally through April 2010.
The Euro crisis
The most recent financial crisis is the one currently plaguing the European Union. This group of 23 countries uses the same currency, but each country’s bond market is independent. So, unlike the United States, none of the countries can create money on its own.
Greece joined the union in 2001, discarding its drachma for the euro. Once part of the union, Greece had access to cheap money and could issue bonds at an interest rate only slightly above Germany. The country obtained billions, borrowing from global banks and foreign pension funds. Government spending soared, and the economy boomed. In 2000-07, the Greek economy was among the fastest growing in the EU at 4.2% annually. The Greek government ran large structural deficits because of a strong economy and falling bond prices.
Investors eventually wised up, as they always do, and realized that despite using the same currency, Greece was not Germany. Greece lost its luster quickly. In the past decade, public sector wages doubled. Public spending surged. Then, when the house of cards started to shake, Greek officials manipulated the books to hide the truth for a few more months.
The problems with Greece are mirrored, if less severe, in the other so-called PIIGS (Portugal, Italy, Ireland and Spain).
The solution promises to be revolutionary, from having a single bond for the entire Eurozone to creating a European Central Bank that can create money with the same ease as the U.S. Fed.
The job problem
Ongoing through these recent crises is a high rate of unemployment in the United States. The 1945-1990 economic recoveries spurred employment. This has not been the case recently, with re-energized GDP rates outpacing the improvement in employment rolls.
Net job growth refers to the addition of new jobs over and above old jobs destroyed. This growth is currently weak not because old jobs are getting destroyed but because new jobs are not being created. The type of jobs needed by any economy shifts over time—from bank tellers to ATM repairmen, from buggy-whip makers to car mechanics, from typewriter assemblymen to fiber-optic cable technicians. In the current U.S. economy, the creation of new jobs has hit a brick wall.
GDP, meanwhile, has continued to rise, from $10 trillion a year in 2000 to around $14 trillion in 2009.
Timing the market
Three important points can be made about the long-term growth of the stock market:
- First, the specific market you invest in matters. For example, the S&P 500 reached its peak for only a month in 2007 and has broken its 2000 peak on two rallies. The Nasdaq, on the other hand, peaked in 2000 and has never come close to re-testing them.
- Second, stock market crashes and extended bear markets are behind long periods of below inflation returns, rather than month after month of sideways market action. This suggests that money can be made during these flat periods by trading the swings effectively.
- Third, the situation would have been even worse without stocks if dividends were out of the picture. Indeed, without dividends, the market effectively was flat from 1929 until 1953.
Combining the above with the realization that history repeats itself, we can lean on our analysis of the major bear markets and financial crises and show how economic data can predict periods of above- and below-normal stock market returns. The result is an invaluable gauge for the markets, guiding us in a new age of active investing.
Murray A. Ruggiero Jr. is the author of "Cybernetic Trading Strategies" (Wiley). E-mail him at ruggieroassoc@aol.com.
