Tuesday, February 24, 2009

How Bad Can It Get?

A lot of what is taken for gospel about bear markets isn't true. The downturns aren't as bad as they seem when you include the effect of dividends.

Before you bail out of stocks -- or start to invest again -- it may be worthwhile to look closely at stock-market history. How bad can the stock market get? How long does it take for you to get even after you hit bottom? The market's history offers valuable clues.

A lot of flawed information about the extent and duration of bear markets is being disseminated today. The information is faulty -- or at least misleading -- because it fails to account for the impact of dividends when computing total returns. Let's look at the real story (the data for this article was supplied by Ibbotson Associates, a subsidiary of Morningstar, the mutual fund tracker).

We'll start with the period from 1966 through 1982 -- an era during which many experts claim the stock market went nowhere. There's a grain of truth in this assertion. The Dow Jones industrial average reached a record high of 1000 intraday in 1966, but then meandered for years. It didn't close above 1000 again until 1972 —- and didn’t close for good over 1000 until 1982. The implication, of course, is that the typical stock-market investor earned nothing over that lengthy period.

But that calculation omits dividends. In fact, Standard & Poor's 500-stock index, the benchmark that most professionals prefer when discussing performance, returned an annualized 6.8% during that 17-year period.

The S&P 500 lost 29% from the end of November 1968 through June 1970. But it took just nine months -- until March 1971 -- for investors who had bought stocks at the peak to break even.

The 1973-74 selloff was one of the three worst bear markets since the Great Depression. The market plunged 43% from January 1973 through September 1974. If you had invested at the precise top, you would have made all your money back by June 1976 -- less than two years after the trough.

The current decade has been far worse than the 1970s. The S&P 500 plunged 47% from March 24, 2000, through October 9, 2002. It didn't recover until October 2006.

The current bear market began on October 9, 2007, and the market had tumbled 50% on a total-return basis through February 23. That makes the current bear market the worst since the 1930s.

Indeed, this decade is already the worst in at least the past 100 years. The S&P 500 has fallen an annualized 3.6% since 2000. That compares with an annualized loss of 0.05% in the 1930s.

The bottom line is that unless we really are embarking on Great Depression II -- or something resembling it -- the worst of the decline is certainly behind us. I think we've already had our "lost decade."

So what happened to stocks during the Great Depression? The answer: terrible things. The market peaked in August 1929 and didn't touch bottom until nearly three years later, in June 1932. At its nadir, the market had lost 83%.

The market didn't decline in a straight line after the October '29 crash. Instead, its fall seemed devilishly designed to ensnare every investor. After sinking 31% by the end of 1929, the market rebounded smartly, gaining 18% by March 1930 before swooning again. Similar sucker's rallies took place over the ensuing two years, luring even investors who had waited for stocks to become cheap before they bought.

The market remained volatile throughout the decade, although the general path was upward. Fierce bull markets were followed by almost equally horrible bear markets. The last ended in April 1942. Hapless investors who bought stocks at the 1929 peak had to wait until January 1945 to break even.

Here again, though, much of the information about how long it took investors to recover from the Great Depression is inaccurate. I've read in numerous places that it took until 1954 for the market to recover. Well, that's true -- but only if you don't count dividends.

For long-term investors, the data about the Great Depression is heartening. If you're 45 or younger, and planning to work another 20 years or so, you can justify investing all of your retirement money in stocks. That is, unless you think this market collapse will be worse than the Great Depression, something that strikes me as utter nonsense. And, by the way, the S&P 500 now yields 3.4%, the highest level it's been at in years, because of the sharp decline in share prices and despite a raft of dividend cuts. That should help boost long-term future returns.

For investors with shorter time horizons, the hard numbers are likewise reassuring. I think the odds are overwhelming that we won't return to the 25% unemployment rate and bread lines of the Depression. Yes, times are tough. I have never seen an economy even remotely this bad. But economists know a lot more about how to get out of messes like this than they did in the early 1930s. And programs such as federal bank deposit insurance, Social Security and unemployment insurance -- not to mention assorted stimulus programs -- should keep the economy from spinning out of control.

Most of us know that large-company stocks have returned an annualized 10% since 1926 -- about twice what bonds have garnered. Inflation, meanwhile, has averaged 3% a year. But over the short term, the stock market is like a roller coaster. The trick is to keep a diversified portfolio, invest regularly until retirement, and not to try to outguess the market's short-term swings -- even swings as gut wrenching as the current one.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.


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