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Friday, February 27, 2009

Stocks Face Long Road Back After Crash - WSJ.com



After the Crash, Stocks May Face Long Road Back

History Suggests There's No Guarantee of Quick Rebound; Buy and Hold -- for Decades?

  • By JASON ZWEIG

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When will the end of the world end?

This week opened with an apocalyptic bang, as the Dow Jones Industrial Average hit an intraday low of 7105.94 -- the index's lowest level since Oct. 28, 1997. It rose Tuesday, then fell again Wednesday. In response, pundits everywhere went picking through their tea leaves one shred at a time, looking for the definitive sign that Armageddon is over, so we can all go back to making money again.

What history shows, however, is that the road to recovery from a catastrophic bear market can be distressingly long.

Friday, finance professor Elroy Dimson of London Business School will publish his periodic update of long-term investment returns, which is eagerly awaited each year among the propeller-heads of the investing world. Along with his colleagues Paul Marsh and Mike Staunton, Prof. Dimson compiles vast amounts of reliable data on 17 stock markets around the world all the way back to 1900.

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Naturally, the report this year focuses on bear markets. The results shocked even me, and I don't startle easily. Consider this: Prof. Dimson estimates that we'll have to wait nine more years before the Dow average, including dividends, has a 50% chance of hitting its 2007 highs.

The report also challenges the conventional wisdom that a run of bad results in the past must be followed by good returns in the future. Following the worst years, stocks outperformed cash over the next five years by an annual average of 7.1 percentage points. But after the best years, stocks outperformed by 6.8 percentage points annually -- a statistical dead heat. "If you were trying to find a rule buried in this as to what investors should do to make money," says Prof. Dimson, "it's kind of hopeless."

The report hammers home another uncomfortable truth. The belief that stocks become virtually riskless if you just hold onto them long enough -- popularized a decade ago in books like Jeremy Siegel's "Stocks for the Long Run" and James Glassman and Kevin Hassett's "Dow 36,000" -- has been shattered by reality. No matter how long your investing horizon may be, the risk of owning risky assets can never go to zero.

Since 1900, there have been four global bear markets in which stocks have fallen by at least 40%, adjusted for inflation. Two have occurred in the past nine years alone. Stocks are risky not merely because their returns are variable, but because they can wipe you out at various points along the way. That's the price you must pay -- often at the worst possible time, and never with a moment's notice -- for the hope of higher returns in the end. That hope is real and valid. It is also uncertain.

"More people are realizing that equities are still risky even over long horizons," Prof. Dimson says. "So I think some of the reasons that people were willing to pay a high price for risky securities have been curtailed." It may be a long time before investors are again willing to value stocks at much higher than the long-term average of 15 times earnings.

That's important. Expectations can be a major factor in stock valuations for years; you don't always get what you foresee. In 1900, for example, many investors were in a triumphal mood, buoyed by the trend toward peace and prosperity. But over the next five decades, all hell broke loose, and global stock markets returned an annual average of just 3.5% after inflation. In 1950, Cold War pessimism was the order of the day, and many doubted whether humanity itself would survive the years to come. But progress prevailed; global stock markets gained 9% a year, adjusted for inflation, over the next five decades.

The mood today is probably closer to the pessimism of 1950 than to the optimism of 1900, which is itself a hopeful sign for the longer term.

Nor are Prof. Dimson's findings quite as discouraging as they sound at first. If there's an even chance that the Dow will nearly double in nine years, that implies a total return of 7.1% per year, which isn't exactly chicken feed.

Since 1900, U.S. stocks have averaged a 6% annual return after inflation. If you knew nothing else -- and none of us do -- then that should be your forecast of the return on U.S. stocks over the long term. That's measured in decades. In the short run, as just about every investor now realizes, anything can happen.

A Liquidity Test

So now is the time to give your entire portfolio a liquidity test. By "entire portfolio," I mean not just your stocks, bonds and mutual funds, but all your assets and liabilities. Do you have enough cash to support yourself (and your family) for six to 12 months if you lose your job? Can you comfortably cover any big expenses (tuition, a house down payment, a wedding) that must be paid in the next few years? Do illiquid assets like real estate or a private business constitute less than half your wealth?

If your answer to any of those questions is no, then you should think twice before sinking more money into stocks. That was true, by the way, even before the bear market.

When to Buy More

If, however, you aren't yet retired and can answer yes to each of those questions, you should have no hesitation about staying in stocks. In fact, you should buy more -- especially if your job security isn't contingent on the health of the stock market. Say, you're a tenured teacher, a member of the clergy, a prison administrator, a funeral director or an Internal Revenue Service agent.

As Prof. Dimson puts it, "If your children will have a wedding in the near future and you absolutely must pay for it, keep your money risk-free. But if you want the chance of giving them a wonderful wedding instead of just feeding a few guests, then you should take the risk of investing in equities."

Abraham Lincoln liked to tell the story of a king who ordered his wise men to come up with a single sentence that would never be false. Their solution, which Lincoln called both "chastening" and "consoling," covered all possible contingencies: "And this, too, shall pass away."

My dad, no slouch in the wisdom department, once shared with me his version of the way to encompass all possible futures: "Hope for the best, but expect the worst." Those, it seems to me, are good watchwords for investors, regardless of whether or not the end of the world has ended.

Email intelligentinvestor@wsj.com

Write to Jason Zweig at intelligentinvestor@wsj.com

Printed in The Wall Street Journal, page D1

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About Jason Zweig

Jason Zweig writes The Intelligent Investor every Saturday for The Wall Street Journal. He is the author of Your Money and Your Brain, on the neuroscience of investing, and the editor of the revised edition of Benjamin Graham's The Intelligent Investor, the classic text that Warren Buffett has described as "by far the best book about investing ever written." Before joining the Journal, Jason was a senior writer for Money magazine and a guest columnist for Time magazine and CNN.com, and he also spent a year studying Middle Eastern history and culture at the Hebrew University in Jerusalem.

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