A Terrible Decade for Stocks -- and Reason for Optimism

It's true: Many investors would have been better off had they put their cash in a money market fund and gone to the beach over the past decade, rather than invest in stocks.

In January 2000, the S&P 500 Index stood at about 1,425. As I write this, it's at 1,120.

If you started investing 10 years ago, you probably want to throw up right about now. To think that the amount of effort and stress that goes into investing has been rewarded with a big, fat nothing is depressing. It's humbling. It's discouraging. It can completely bodyslam your faith in investing. I hear you loud and clear.

What it should not do, however, is ruin your outlook for the next decade. Quite the opposite, in fact.

Even though the past decade brought negative returns, we need to acknowledge three important points:

1. This isn't the first time it's happened.
2. It's never happened two decades in a row (if we start with base years, '00, '10, '20, etc.)
3. The ensuing decade after a negative return decade has been consistently quite good.

Going waaaay back
Yale economist Robert Shiller keeps a database of S&P 500 prices going back to 1871 (bless him). Taking his data and breaking it into 10-year periods yields the following returns:

*As of Dec. 23.

Of course, you can tweak the starting year and come up with different results. But in general, the pattern isn't too different. For example, starting with the fifth year of each decade:

A related table I put together for another article using the Dow Jones Industrial Average shows similar returns:

What's it all mean?
These are big, broad tables, so the takeaway from them should be big and broad as well:

After booms come busts, and after busts come booms. That's how markets work.

When you take this view, it becomes obvious that the single most important variable in determining future returns is the starting price. That stocks posted negative returns over the past decade should surprise no one -- starting at the peak of the dot-com bubble in 2000 means we needed miracles just to break even. Ditto for the late 1920s and late '60s. It's like trying to run a marathon after not sleeping for three days. Or starting an eating contest right after Thanksgiving dinner. You'll fail. Hard.

Conversely, when you start a period wrapped in pessimism and despondency, the odds that you'll finish on an up note are quite good. That's just what happened from March of this year through today, as the S&P 500 surged over 65% even as hundreds of thousands of jobs were lost. When the starting point is formed by people who think the world is about to explode, the economy doesn't need to achieve anything remarkable for stocks to score incredibly remarkable returns.

That's why some of the biggest gains since March came from companies like Ford (NYSE:F), Citigroup (NYSE:C), and Sirius XM (NASDAQ:SIRI). On the other hand, Yahoo! (NASDAQ:YHOO) saw revenue shoot up nearly eleven-fold over the past decade, yet shares fell 80% during that period. I'll say it again: The single most important factor in determining future returns is the price of your starting point.

Reasons to be optimistic
The good news is that there are currently plenty of high-quality companies trading at attractive valuations, upping the odds of strong returns over the coming decade. Check out Procter & Gamble (NYSE:PG) at 15 times 2010's earnings. Or Johnson & Johnson (NYSE:JNJ) 13 times next year's earnings. Others might like AT&T (NYSE:T) with a 6% dividend yield. It's still a fruitful time to be an investor, Fools.

No one has a clue what's going to happen over the next decade. But if the history of markets going back almost to the Civil War is any indication, the odds that the next decade will be more prosperous than the last are fairly good.

Here's to a happy new year, and an even happier new decade.