Chill Out About Stocks' "Lost Decade"

On September 7, 2000, the Dow closed at 11,259. This morning, exactly 10 years later, it's holding tight at around 10,450.

There's the "lost decade" for you. Add in dividends and it's not quite as bad. But there's no question about it: The past 10 years have been absolutely horrendous for stocks.

Serenity now
Patience has been pushed to the limits. That's  given. I can't count how many news articles I've seen profiling frustrated investors who are ready to throw in the towel. They assume market returns from most of the post World War II through the late '90s were a fluke, unlikely to ever be repeated again. As volatility jumped over the past few months, there's been an almost Pavlovian-like uptick in this sort of response. "[The] market hasn't gone ANYWHERE in 10 years" a caps-happy reader recently emailed me. "Only a FOOL can look at that and STILL BE LONG STOCKS RIGHT NOW."

I don't buy it. If we're going to dwell relentlessly on this lost decade, let's get an important point out of the way: 2000 was the peak of the most wacked-out stock bubble the world had ever seen. As long as 2000 is used as a base year, any and every historical comparison will look atrocious.

In 2000, the S&P 500 traded at an insane 28 times trailing earnings. That was a recipe for sheer misery, which is exactly what followed. And most people knew it. As early as 1996, analysts were getting nervous -- that's when Alan Greenspan gave his "irrational exuberance" speech. By 2000, you had to be delusional not to see it.

As I remember it, just about everyone knew stocks were a bubble bound to burst, but they didn't want to leave any money on the table. So they stayed in, confident of their ability to get out before the carnage hit. This attitude -- that markets were blatantly overvalued but should still be bought with abandon -- created a complete disconnect between stocks and the value of their underlying businesses. And that disconnect robbed future returns. By soaring an average of 25% per year between 1995 and 1999 when business performance justified nothing of the sort, the Dow was guaranteeing that future earnings improvements would not be rewarded with higher stock prices.

And that's exactly what happened. Consider that as stocks lost ground over the past decade, S&P 500 earnings have actually grown 51%. Dividends? 42% growth. These growth rates aren't spectacular, but they uncover an important point: Lousy returns over the past decade had little to do with what happened during those 10 years, and a lot to do with where we started 10 years ago. By starting with painfully high valuations, stocks were ensuring poor returns from Day 1.

Paid for performance?
To show how powerful this phenomenon was, take two companies: Microsoft (Nasdaq: MSFT  ) and Altria (NYSE: MO  ) .

Since 2000, Microsoft has roughly tripled revenue, and more than doubled net income per share. What did shareholders get for this performance? A stock that's fallen more than 50% from its 2000 high.

Altria, on the other hand, has barely grown revenue, and actually saw operating profit climb only 10% or so over the past decade (adjusted for all spin-offs). What did shareholders get from this performance? A stock that's surged 240%, plus an annual dividend that typically hovers around 6%-8% per year.

The only difference between these two outcomes is that, 10 years ago, Microsoft had implausible expectations and traded at an outrageous valuation, whereas most people forgot Altria even existed. More than earnings, more than GDP, and more than interest rates, the single most important factor that determines future returns is starting valuation. That's the only reason we've had a lost decade.

Moving on
So where are we today? Pretty close to the polar opposite of 2000.

The S&P trades around 14 times trailing earnings. Dividend yields are higher than Treasury yields for the first time in half a century. Hedge fund managers are giving up. Piles of high-quality stocks, from Pfizer (NYSE: PFE  ) to Oracle (Nasdaq: ORCL  ) to General Electric (NYSE: GE  ) , now trade at a fraction of the valuation they did 10 years ago. Back then, Dow 36,000 was one of the most popular books. Today, The Great Depression Ahead is flying off the shelves.

Ten years ago was the time to be worrying about a lost decade. Not today.         

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Microsoft and Altria. Microsoft and Pfizer are Motley Fool Inside Value recommendations. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Altria Group and Oracle. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 07, 2010, at 5:13 PM, nprfreak wrote:

    Very good article. I've seen some recent posts around the internet that cite 1999 as the comparison year, probably to make the comparison look even worse. (If I recall, much of the decline was behind us by Sept 2000.) It will be interesting to see how the "last decade" will look in 2012.

  • Report this Comment On September 07, 2010, at 7:21 PM, richsue3 wrote:

    At least by still TRYING in stocks, I feel like at least I am goig down swinging. Investment in MLP's have been somewhat a savior at this point and would suggest looking there. Just offering a point of view - not promoting any specific one.

  • Report this Comment On September 07, 2010, at 9:55 PM, ChrisBern wrote:

    Ahh, you had me until the "Moving On" section.

    Completely agree with the first part--the past decade's lousy returns were almost entirely a reflection of the initial (over)valuation.

    However, the only way to properly analyze market valuations is with cyclically-smoothed earnings, e.g. Shiller's PE10. Today the PE10 stands at 19.94. The average PE10 dating back to 1881 is 16.37. Today's number, therefore, is 21.8% higher than the historical average.

    Could the PE10 be trending higher, to the point where taking a 129-year average is no longer relevant? Maybe. But the average over the last 50 years is still 19.41...still lower than today's 19.94.

    I can't speak for anyone else, but I can't get excited about the current equity price level given that we're facing so many economic headwinds right now.

  • Report this Comment On September 08, 2010, at 5:31 AM, BearishKW wrote:

    "On September 07, 2010, at 9:55 PM, ChrisBern wrote:

    Ahh, you had me until the "Moving On" section.

    Completely agree with the first part--the past decade's lousy returns were almost entirely a reflection of the initial (over)valuation.

    However, the only way to properly analyze market valuations is with cyclically-smoothed earnings, e.g. Shiller's PE10. Today the PE10 stands at 19.94. The average PE10 dating back to 1881 is 16.37. Today's number, therefore, is 21.8% higher than the historical average.

    Could the PE10 be trending higher, to the point where taking a 129-year average is no longer relevant? Maybe. But the average over the last 50 years is still 19.41...still lower than today's 19.94.

    I can't speak for anyone else, but I can't get excited about the current equity price level given that we're facing so many economic headwinds right now."

    ...................................................

    Call me crazy, but if you're a believer in this can't you simply buy good stocks that are trading under a P/E of 16? They are not hard to come by in this current market.

  • Report this Comment On September 08, 2010, at 10:46 AM, FutureMonkey wrote:

    @ChrisBern. I gave Ed Easterling's "Unexpected Returns" a good hard read about 5-6 years back. Worth reading again. He has a similar view as Schiller on long term secular bear and secular bull markets over the last century. One of the important points is that bear cycles don't end when valuations hit historical average relative to earnings, but actually dip well below average before the beginning of a new long term secular Bull (1982-1999). That doesn't necessarily mean that valuations will go lower tomorrow or even this year, but earnings will need to continue to rise before the returns on value rewards investors. I see a lot of sideways chop for several more years until interest rates, inflation, and demand drive profits up faster than market valuation. The profit growth of 51% (broad SP500) that Morgan cites over the last decade was in large part due to reduced taxes and cost control measures rather than growth in demand. That ain't good. Potentially could see single digit P/E on the SP500 before we see equities investments start to reward investors with "historical average returns." Doesn't mean that anybody should be fleeing the stock market, rather than expectations for returns should be tempered. Nobody knows exactly when cycles will change and individual years may be strong during bear cycles, so being out of the market probably won't work as a strategy. I'm a dollar cost averager with retirement in 2035, so my horizon is far away. I expect to be rewarded for saving now, just not next month, next year, or even 5 years from now. As long as I preserve capital and beat inflation (not to hard this year) I'm good.

  • Report this Comment On September 08, 2010, at 6:52 PM, knighttof3 wrote:

    Has no one here read Ben Graham? When bonds yield less than stocks, that's the time to BUY stocks!

    I am jumping with both feet into stocks with low P/E, respectable-but-not-too-high dividend, low debt, and some growth over the last ("lost") decade.

    I tip my hat to those who can predict the future of broad markets for years ahead. But for them the rest of us could not succeed.

  • Report this Comment On September 08, 2010, at 10:19 PM, TheDumbMoney wrote:

    I agree with a prior commentor. Despite my enthusiasm about the fact I can earn more in dividend yield on a good stock than in a good bond or a T-Bill or T-Note or T-Bond, the 2010 PE10 is less than encouraging, and while that metric has its limits, too, it still reduces my optimism quite a bit -- well below the level of wild-eyed zeal. See here for the historical data: http://www.econ.yale.edu/~shiller/data/chapt26.xls.

    That said, we're indeed in a much better place generally for buying stocks than we were in in 2000. And to some extent the PE10 for the broader market is reflective of excessive enthusiasm about particular stocks, not the market as a whole. This is confusing, but ultimately encouraging I think.

  • Report this Comment On September 09, 2010, at 2:05 AM, mtracy9 wrote:

    While this was the worse decade for stocks since the end of WWII, there have been other less than stellar decades. The S&P only returned 5.9 percent during the 1970s. Looking back we should have anticipated a dismal decade for stocks after the two great back-to-back decades of the 80s and 90s. In the long term, the law of averages always prevails.

  • Report this Comment On September 10, 2010, at 12:53 PM, talotu wrote:

    "Polar opposite to 2000" is too extreme. Right now stocks are more or less fairly valued as a group on the whole. In early 2009 valuations were low, but right now they seem reasonably sane.

  • Report this Comment On September 10, 2010, at 2:15 PM, wdavid74 wrote:

    I have read the dow 36000 and if you take a look at big Mo and add the 240% the dow would be at 27000 now given the 11k valuation. It is in my opinion that the dow, much like everything else is controlled and manipulated to serve someone else's interest. Just like articles. Anything I read I take it with a grain of salt. I continue to do my own research and make the decision based on company fundamentals. The only thing I can think of is that someone wants to get rich on these index annuities and it's very possible that stocks are traded and indexes are created and underlying securities added or removed to obtain a certain price. Possibly if others such as MO was used and an index is created we could come up with a dow 27000 or even a dow 200000. But then none of the insurance companies could afford the profit taking on the annuities causing a collapse again.

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