History Matters: Learning the Lessons of "The Lost Decade"
On many occasions during the past year, I've seen and heard the past 10 years dubbed as "The Lost Decade." From a stock market perspective--with prices essentially flat between 2000 and 2010--it's not hard to understand why. Upon writing this article, the annualized return on the S&P 500 over the past 10 years was -0.68 percent, versus the average return of 6.28 percent since 1929 (according to FactSet Data Systems). Interestingly, over a similar time frame, aggregate corporate profits have doubled while total household net worth is about 50 percent higher.
While the stock market seems to say we've made no progress, economic statistics indicate otherwise. So why the disparity? For a better understanding, enter our lessons learned from the past decade.
- Lesson 1: Starting point/valuations matter. By the end of 2000, the S&P 500 was coming off a five-year period in which it had advanced, on average, 25 percent per year. The price-to-earnings ratio stood at over 30x--the highest on record and several standard deviations above the norm. These levels were attained after a decade that had experienced only nine months of recession and no stock market correction that lasted more than three months. From a market perspective, the decade that ensued was not a reflection of lousy economics as much as it was inflated starting valuations.
- Lesson 2: Leverage matters. In all parts of the financial system, leverage (debt) grew throughout the last two-plus decades. The escalation actually began in the 1980s with dramatically declining interest rates, easier lending standards, and changing tax laws that encouraged spending and credit. Leverage is exhilarating in growing markets because it magnifies the upside. However, problems become apparent when asset values stop appreciating. The situation obviously becomes intensely magnified when those values depreciate as rapidly as they have in the past decade.
- Lesson 3: Wherewithal matters. Controversial British economist John Maynard Keynes is credited with quipping, "The market can stay irrational longer than you can stay solvent." Over the past decade, this observation has been validated time and time again. When things quickly became ugly in late fall 2008, hedge funds were forced to disgorge anything remotely liquid (like high-quality municipal bonds) to meet margin calls on other assets. As banks reduced credit limits and called lines, individuals were subsequently forced to sell stocks and bonds to meet margin calls and to pay down loans. Millions of Americans found themselves one medical emergency or layoff away from losing the house, car, etc. because they hadn't built enough wiggle room into their financial situations. Moreover, millions had counted on home or 401(k) appreciation as "savings" because more liquid (and old-fashioned) savings accounts were "boring" and low-yielding. Throughout the food chain, assumptions pertaining to our capacity to earn and repay had been too optimistic, and our ability to adapt to extraordinary events was severely tested.
- Lesson 4: Incentives matter. Knowing how people are compensated is a key factor in trying to predict behavior and outcomes. If someone somewhere had paid attention to the fact that mortgage bankers were incentivized to move volume rather than write good loans, perhaps the outcome would have been different. Similarly, many remain angry that companies like Goldman Sachs rebounded so quickly from the traumas of 2001-2003 and 2008-2009. Yet it's important to remember that a key component of revenue for many Wall Street firms is trading volume. They really don't care if markets go up or down as long as trading happens.
- Lesson 5: Costs and withdrawal rates matter. In a low-return environment like the one we've been experiencing, costs and withdrawal rates become even more important. In the late 1990s, with markets growing 25 percent annually, it was easy to withdraw 5, 10, or 15 percent of a portfolio every year and still see growth. Similarly, government and municipal budgets could easily become bloated on the back of increased property and income taxes. When market returns flattened and tax revenues declined, spending/portfolio withdrawal rates became intensely apparent and impactful.
- Lesson 6: Volatility doesn't matter as much as you think it does. In fact, it presents a lot of opportunities. The money management industry has tried to simplify the concept of risk by equating it with volatility, (i.e., the day-to-day ups and downs of the capital markets). While such vacillations are psychologically trying, they really shouldn't matter as long as you 1) paid a reasonable price relative to fundamentals for your asset, and 2) don't need to hurriedly sell that asset. In fact, when valuations gain momentum and intensity, moving in the opposite direction can be beneficial to your long-term net worth.
The first decade of the 2000s clearly was much more challenging than the decade that preceded it, with plenty of age-old lessons to be reminded of. Let's hope the next 10 years turn out to be a lot more fun, given all the wisdom we've gained!
Carol M. Clark, CFA, is a partner and investment principal of Lowry Hill, a private asset management firm that provides proprietary investment management and financial services to families, individuals, and foundations with wealth greater than $10 million. The firm manages approximately $6 billion in assets for nearly 300 families and more than 60 foundations from offices in Chicago, Minneapolis, Naples, and Scottsdale. She welcomes questions and comments at firstname.lastname@example.org.
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