If History Is Any Guide, It’s Time to Lower Sights for Stock Returns

What would you consider a good return on your investment portfolio this year? How about for the next five years?

Those questions are more than academic, especially in the wake of last year’s stock market losses. After five years of 20%-plus annual returns, the blue-chip Standard & Poor’s 500 index fell 9.1% in 2000 (that includes dividend income).

One down year after so many great years shouldn’t, by itself, be a major cause for concern, of course. Say you’ve been in the market since Jan. 1, 1995, when you were smart enough to put $25,000 into an S&P; 500 index mutual fund. By Jan. 1, 2000, your investment had grown to $87,750.

Even with last year’s slide, and the 0.1% dip in the S&P; so far this year, you’ve still got about $79,700 in that account.

The problem for many people who have enjoyed the equity returns of the last decade or so isn’t in dealing with last year’s results, but in accepting that the next 10 years might not be so generous. Or perhaps you may say that you can accept lower returns, but your long-term lifestyle plans are based on the kind of percentage gains generated since 1995.

Veteran investors have heard these warnings before, and the truth is that, for nearly 20 years, they have been better off ignoring them.

For example, after the market crash of October 1987--which followed five stellar years on Wall Street--many analysts predicted subpar stock returns for years to follow because they figured investors would be too shellshocked to jump back in.

Wrong. The S&P; 500 rose 12.4% in 1988 and surged 27.3% in 1989.

In 1994, the market ended slightly lower as the Federal Reserve drove interest rates up to cool the economy. The year’s losses followed modest gains in the S&P; 500 in 1992 and 1993. As 1995 began, many Wall Street pros were telling clients to expect average returns, at best, from stocks in the latter part of the ‘90s.

Wrong again.

Still, the warnings over the years were rooted in sound investing logic--mainly, in the idea that market returns ought to “regress “ to the historical average.

That’s a statistician’s way of saying that far-above-average returns can’t be sustained, if you believe that a historical average means something. Mathematically, far-above-average returns must be followed by well-below-average returns to bring the annualized return for the entire period back toward the average.

But a key assumption of return regression is that the historical average does mean something. Some market bulls argued in the 1980s and 1990s that the historical average return on major U.S. stocks (which had been 9% to 10% a year from 1926 to 1980) wasn’t indicative of what was to come, because the future would be far more favorable an environment for equity investing.

*

That argument gained more followers in the 1990s, as the Soviet Union fell, inflation evaporated and capitalism appeared to triumph worldwide. Given those developments, the bulls said, there was good reason for market returns to be far above the pre-1980 experience. In effect, the bullish case was for a major upward adjustment in the market’s long-term average return, befitting a “new era.”

And that is just what we’ve had: From 1982 through 1999, blue-chip stocks (the S&P; 500) returned more than 19% a year, according to Vanguard Group calculations. The long-term annual average return on the S&P;, dating back to 1926, is 11.3%, pulled up by the results of the last two decades.

Robert Farrell, Merrill Lynch & Co.’s long-time market analyst and now the firm’s senior investment advisor, says the 1982-99 period was “the longest period in history of far-above-average stock returns.”

So, now what? To Farrell, 2000 was a taste of what’s to come, not a short-term interruption in another decade of high returns.

He isn’t making some blanket argument against owning stocks (and, of course, you wouldn’t expect that someone at a major brokerage would argue against stocks in general). But Farrell insists that, after two decades of extraordinary returns in the market, investors must be prepared to earn much less.

“Every market will eventually find a reason to regress to the mean,” Farrell wrote in an extensive report Merrill published in December. “Because we know that markets do regress and often overshoot in the opposite direction, we have important clues to what to expect in the future.”

He continued, focusing on the tech stock boom and bust of 2000: “Every period of speculative excess in history has been followed by a cycle of wealth destruction that takes back most or all of the gains of the prior boom. Rallies notwithstanding, the correction of major market excesses takes time--usually several years--and the environment changes dramatically.”

It already is changing, he noted, with the reemergence last year of “value” stocks as investor favorites after more than two years in the doghouse while the tech sector reigned.

All in all, Farrell contends, a “common-sense approach tells us to expect lower rates of return from stocks over the next five to 10 years or more. After 18 fat years with returns averaging 18% to 20%, we are more likely to have a stretch of lean years with returns of less than 10%.”

Investor surveys suggest that most people don’t buy that scenario--at least not yet.

A monthly survey of 1,000 investors by PaineWebber and the Gallup Organization shows that the average expected portfolio return over the next 12 months stood at 11.8% as of the December survey.

That figure has dropped sharply over the last year (it was 18.4% in the December 1999 survey), but it still is above the 11.3% return that is the long-term average return back to 1926.

If you believe that regression is underway, even 11.3% is probably too optimistic a figure for an annualized average return in this decade, according to Farrell.

How low could returns get? Historical comparisons are imperfect for obvious reasons (every era is different in some ways), but some Vanguard Group data at least offer sobering food for thought:

* The U.S. market generated an average annual return of 27.1% from June 1949 to April 1956, a seven-year bull market. But from April 1956 to June 1962, the return averaged just 5.6% a year--regression at work.

* From June 1962 to November 1968, the average annual return was 14.8%. But from November 1968 to April 1980, the annualized return fell to a mere 4%.

Market return numbers can be skewed, of course, depending on where in a bull or bear market cycle you choose to begin and where you choose to end. Still, the message from past cycles is clear: Fat years can give way to some very lean years.

At the beginning of 2000, investors who snickered at the idea of an extended period of lean years for the market had the fundamentals on their side: Corporate profit growth was surging, energy prices still seemed relatively under control, and the economy was roaring.

With the reversal of those and other fundamental supports for the bull market in recent months, however, a long, lean period may not seem quite so outlandish to more investors.

Let’s assume Farrell is right, and U.S. stock returns are coming down. Many investors still would argue that they have to be in the market, and that makes sense.

But depending on your age and your risk tolerance, an expectation of lower stock returns could prompt you to rethink your portfolio mix.

For instance, if stock returns are coming down to, say, 8% a year over the next five years, holding a larger portion of your portfolio in bonds might seem more attractive, given the relative returns of bonds versus stocks. (That may be part of what fueled the rush into Treasury and municipal bonds last year.)

Holding more money in “cash” accounts (such as money market funds) also may become more appealing, depending on where yields on those accounts settle and how much or how little you expect from stocks.

*

Investors might also begin to look more to other types of assets--foreign stocks or real estate, to name two--as opposed to adding more money to their U.S. stock accounts.

The point is, for the last five years, really the last 18, the smart strategy has simply been to stay in U.S. blue-chip stocks and ignore virtually every other asset class.

Despite the argument that the fat era is coming to an end, no one can tell you for certain that, 10 years from now, we won’t be marveling once again at how spectacular the returns have been in the U.S. market.

But to make that bet now--without any meaningful kind of hedge in the form of portfolio diversification--is to crawl further out on what is arguably an increasingly thin branch.

*

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to https://www.latimes.com/petruno.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

What People Expect to Earn

A PaineWebber/Gallup monthly survey of 1,000 investors shows how portfolio return expectations have come down over the last year--though they still are above the historical average annual return on blue-chip stocks, which is 11.3%.

*

Expected rate of return over the next 12 months

December: 11.8%

Source: PaineWebber/Gallup investor survey