Yes, Stocks Have Outperformed--Most of the Time


For nearly two decades, baby boomers have been carpet-bombed with financial information. But it all came down to one line: "Over the long term, history shows that stocks outperform all other markets." After all, for about 60 years, U.S. equities have returned an average of roughly 11% a year.

"Buy and hold" became the mantra of the bull market, "market timing" a dirty word. And in the vocabulary of conventional wisdom, market timing didn't mean speculation (in by 10, out by 4). It meant selling stocks any time before you retired.

And no wonder: Equity markets have been soaring steadily for decades--or so it seems--not only in the U.S., but worldwide.

Since its inception in 1970, Morgan Stanley's index of stocks in Europe, Australia and the Far East (EAFE) has climbed an average of 11.66% a year (9.84% in local currency terms).

Moreover, evidence shows that "80% to 90% of investment returns have occurred in spurts that amount to 2% to 7% of the total length of time of the holding period," said John Spears of Tweedy Browne & Co. "The rest of the time, stocks' returns have been small. You have to be in to win."

Even today, many individual investors cling to the buy-and-hold philosophy as they shrug off losses of 15% to 20% in both the U.S and Europe.

But what's strange is that despite all of the talk about history and the long term, the time lines that you see these days rarely go back much more than a dozen years. Even now, as the myth of a new era begins to dissolve, few commentators are looking back farther than the '80s.

Nevertheless, they've all become market timers.

Abby Cohen, Goldman Sachs' optimistic market strategist, says it's time to buy--recommending that you boost the share of stocks in your portfolio to 72%, up from 65% a week ago.

On the other hand, Richard Bernstein, chief quantitative analyst at Merrill Lynch, advises lightening up, reducing stocks from 55% to 50% of your portfolio.

But how do they know?

If you're going to time a market, you need a clock, a calendar, a chart. . . . In other words, you need to step back and put the present moment in context.

A few commentators have provided snapshots of past bear markets. We're told, for instance, that in the U.S. there have been just five declines of 20% or more since World War II. And only two bear markets were long-lasting: the 48.1% collapse that began in January 1973 and continued through November 1974, and the 27.1% plunge extending from November 1980 to August 1982.

But few connect the dots.

It turns out that if you trace the progress of the Dow Jones industrial average from 1960 until the end of last year, the line is fairly flat. For the 23 years ending in 1983, investors were sandpapered to death. The Dow averaged 1.9% a year; the S&P; 500 3.78%.

That's because, in between the end of the bear market of 1974 and 1980--when another decline began--the Dow advanced an average of just 5.69% a year.


The S&P; did much better--returning 14.94% annually. But even that wasn't enough to compensate for the crash of '73.

It turns out that an investor who inherited money in 1960, plunked it into U.S. equities and held them for 37 years made just 7.6% a year on the S&P; 500 (6.67% on the Dow).

Hardly a tragedy, but far from what today's investors have been led to expect from U.S. stocks.

In the end, whether you're investing in markets in the U.S., Europe, Asia or all three, everything depends on beginning and ending points--when you get in and when you get out. Even if you invest steadily year after year, you'll still have to sell sometime. And contrary to popular wisdom, holding long term doesn't give you a lock on a double-digit return.

Indeed, if you put your savings in the S&P; and hold for 10 years, chances are only 53% that you'll make more than 10% annually--and the odds are 4% that you'll lose money, points out Newsweek columnist Jane Bryant Quinn, using annualized monthly returns on the S&P; 500 going back to 1926.

Buy and hold for 20 years--and your chance of earning more than 10% rises to 67%--still far from a guarantee.

That suggests why market timing outperforms a simple buy-and-hold strategy in recent studies of Dow theory. The work was done by Stephen Brown, William Goetzmann and Alok Kumar of Yale University.

The study "shows that a portfolio that follows the theory's market-timing signals from 1929 until today beats a buy-and-hold portfolio that's also investing in a hypothetical index fund by 2 percentage points a year--and the volatility is cut by a third," said Mark Hulbert, editor of the Hulbert Financial Digest, a newsletter that tracks other financial newsletters, including market timers.

Is this because market timers do better in bear markets? "The value is more apparent in bear markets. To say it does better is like saying that fire insurance does better when there is a fire."

Market timers don't provide all the answers--but buy-and-hold-forever isn't the solution either. For when you step back and put markets into a larger context, it's clear that cycles (however irregular) are built in.

What determines the cycles? The short answer is earnings, and even now, prices are still high compared with profits, with price-to-earnings ratios among S&P; 500 companies still averaging around 23, even higher in Europe.

Meanwhile, earnings estimates are sliding both in the U.S. and Europe. In the U.S., 2% to 3% growth is likely in the third quarter, zero quite possible next year. As for Europe, Goldman Sachs has reduced its 1999 earnings estimate from 11% to 9%.

Ultimately, strategic market timing is old-fashioned value investing. No elaborate market-timing theory necessary.

Is this a buying opportunity? Perhaps--in places like Japan, if you steer clear of exporters.

But that's another column.


The Dow From 1960 to 1980

Historical perspective can help investors understand potential market cycles. Although the stock market has provided the highest returns of any general category of investment over the entire century, individual returns always depend on time of purchase and sale, even for decades-long holders. Some long-term periods have provided minimal returns. For example, the Dow ended 1980 essentially where it was in 1965. From 1960 through the end of 1972, and again from 1974 to 1980, annual average returns were about 5%--particularly meager during the high-inflation mid-'70s.

1980: 963.98

Source: Bloomberg News

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