By Brad McMillan, CFA®, Vice President, Chief Investment Officer, Commonwealth Financial Network
During my career, I have lived through Black Monday (1987), the Friday the 13th mini-crash (1989), the real estate and savings and loan crisis of the early 1990s, the Asian Financial Crisis (1997), the Russian financial crisis and collapse of the Long-Term Capital Management hedge fund (1998), the dot-bomb crash (2000), the crashes of 2008 and 2009—and now the European crisis and crash of 2010. For a young guy, that seems like a lot.
As this list should demonstrate, though, market declines and financial crises are actually pretty common. Most of us have lived through, and ridden out, several—and even made money over time despite them. The European crisis is only the most recent. We can’t make light of it, because market movements affect the emotions and lives of millions of people. But we also shouldn’t make more of short-term market movements than they really are. In the context of a prudent financial plan, market movements are like storms at sea. While they can overwhelm small or poorly sailed vessels, properly designed and sailed ships tend to come through the turbulence just fine.
Market past and present—a look at subsequent returns
To illustrate this concept, take a look at the past and present of the market. We are in the midst of a serious crisis, we hear, and the market is in freefall. Let’s consider the scariest part first: the current 10-percent-plus decline in May. Surely this signals a continued bear market—right?
Not necessarily. We looked at the past 40 years to identify monthly declines of 10 percent or more in the S&P 500 Total Return Index; then we examined the subsequent performance of the market. Here’s what we found.
| Subsequent Annual Returns, S&P 500 Total Return Index | |||||||
| Month | Return | 10-Year Hold | 5-Year Hold | 3-Year Hold | 1-Year Hold | To 5/20/2010 | |
| November 1973 | –11.1% | 9.4% | 1.5% | 2.5% | –28.8% | ||
| September 1974 | –11.5% | 14.2% | 13.9% | 15.2% | 26.2% | ||
| October 1987 | –21.5% | 14.7% | 9% | 1.9% | –12.4% | ||
| August 1998 | –14.4% | 2.9% | –1.1% | 3.9% | 20.2% | ||
| September 2002 | –10.9% | 12% | 12% | 12.1% | |||
| October 2008 | –16.8% | –6.9% | 10.6% | ||||
| February 2009 | –10.6% | 50.3% | 45.8% | ||||
Source: Commonwealth Financial Network® Research
Each of these months in the chart experienced its own crisis, just like today. While not to minimize the potential short-term effects of such a drop in the index—1973 was a tough year for investors, and 1987 results didn’t fare much better—the odds are in favor of an investor with a 5- or 10-year projected holding period doing quite well. The worst 10-year results (August 1998) started in a boom and ended in a crash, with another crash in the middle. Where we are right now is much more like a crash than a boom, so it is reasonable to expect that 10-year results (looking ahead to May 2020) might be more like the 10-year results for 1973, 1974, and 1987. So, in the intermediate to long term, we believe a rough month like May 2010 doesn’t necessarily mean that subsequent results will also suffer.
Market valuations vs. going-forward results
Another way to look at current market conditions is to compare going-forward results based on market valuations. We used the Shiller price-to-earnings (P/E) ratio, based on 10 years of averaged earnings. The advantage of looking at this metric is that average results are taken over a full business cycle and are relatively unaffected by short-term accounting gimmicks. The Shiller P/E based on the May 20 close was 19.4. Looking at historical data, we identified the going-forward returns for comparable valuation levels.
| Annual Returns by Valuation Level, 1979–2009 | |||
| 10-Year Hold | 5-Year Hold | 3-Year Hold | |
| Maximum | 14.45% | 28.54% | 31.13% |
| Minimum | 6.67% | –0.19% | –4.87% |
| Average | 11.11% | 19.61% | 15.44% |
Source: Commonwealth Financial Network® Research
From this chart, we can see that there is the potential for negative results in the intermediate term. Yet we believe that the average results and the minimum 10-year results are within a reasonable range, and they certainly don’t imply disaster. Even the average results for the shorter-term holding periods indicate that the odds are with the investor who can wait out a market correction.
Estimating the equity risk premium
Some analysts might argue that because the current market is seriously overvalued, despite the above results, subsequent returns are bound to be poor. Again, not necessarily. We looked at valuation levels in the previous section, and the data seems to indicate that current valuation levels are not out of a reasonable range. They are above the long-term average of 16.36, however, which suggests that a closer look is, in fact, warranted.
Valuation levels do not exist in a vacuum. They are influenced by, among other things, interest rates paid by fixed income instruments. One way of looking at the reasonableness of valuation levels compared to interest rates is by estimating the equity risk premium (ERP). This is the amount by which the equity market’s earnings yield (earnings divided by price) exceeds the interest rate paid on equivalent bonds. By this metric, stocks are still reasonably valued—in fact, they’re cheap!
The current ERP is around 1.4 percent—well above the historical spread, since 1970, of –0.78 percent. Over the past 40 years, the ERP has tended to be negative, rising into positive territory during times of market stress, like today, then declining again. This is consistent with the longer-term results reported above and suggests to us that we can expect reasonable longer-term market performance.
Calm and focus are key
These arguments are not intended to suggest that the market has bottomed. It may continue to decline—maybe even retest its lows. Short-term results could be disheartening (see the 1973 one-year results). Over time, however, those who rely on a diversified portfolio and professional advice in navigating a choppy sea may be better positioned to benefit when the market does rebound. And keep in mind that the results outlined in this commentary are based on an equity-only portfolio—something which few people probably have and even fewer should have. We would expect the results from a professionally developed financial plan, when bonds or other asset classes are included, to be even better, as diversification can benefit a portfolio over the long term, and there are also more products on the market to help advisors and investors better manage risk.
This is the time in the market when calm and a focus on long-term goals are critical. We have seen a similar situation twice in the past couple of years; those who sold at the bottom in March 2009 missed the subsequent recovery. Those who sold at the bottom of the “flash crash” just a few weeks ago missed that same-day recovery! The ride can be rough, but with a properly designed portfolio and a historical perspective, you’ll be in a better position to ultimately get where you want to go.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Total Return Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks and includes the effects of dividend reinvestment. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.
© 2010 Commonwealth Financial Network®
