excess of sixteen percent. This pattern of long periods of sub-par returns followed by long periods of excellent returns is by no means unusual. It has occurred frequently and merely demonstrates that stocks are mean-reverting.
In a recent paper for Vanguard’s Institutional Investor Group, Francis Kinniry Jr. and Christopher Philips write “The returns from any particular period are an unreliable anchor for long-term return expectations.” This applies to even longer horizons of ten or twenty years. By way of example, when calculating ten-year returns, shifting the start date by four years changes eighty percent of the data. For longer periods, say twenty-year returns, a shift of six years changes sixty percent of the data. Why is this important? Because by lopping off a series a poor performing years, or adding a series of good performing years, the picture painted by a particular asset class- in this case stocks- can be misleading. Without trying to get too technical, the paper goes on to point out that although stocks have a mean annual return of ten-percent for all ten year periods since 1926, “investors can reasonably expect to see a ten-year return average between 0% and 20% about 95% of the time.” Quite a range and interestingly, fairly close to the wide range of returns investors experienced in the personal example cited above.
Our last correspondence to clients was in November 2008 (to access the letter go to: http://www.highlandercapital.com/commentary.php). Since then, the credit markets have thawed and prices of many corporate and municipal bonds have rallied. While we were able to pick up many bargains in the fixed income arena at exceptional prices and yields, the equity markets have continued their losses into the new year with the S&P 500 -14% through late February. As I indicated then, many businesses were priced for insolvency or at the very least, sharply diminished future earnings. While it is obvious that short-term earnings will be impacted, it by no means obvious that the long-term picture has been fundamentally altered. Aggregate corporate profits over long periods of time have always grown; albeit not in a linear fashion. It is true that some poorly capitalized or uncompetitive businesses will fail and have to be shuttered or reorganized. Equally true is the fact that inventories will ultimately clear, loans will stop souring, bank balance sheets will mend, demand will pick-up, and growth will resume.
For forward looking investors, there is a very high probability that the aggregate earnings of the S&P 500 will be meaningfully higher in ten years. This, coupled with the very large decline in prices of common stocks and the high dividend yields relative to bonds suggests to us attractive prospects for equities.
In closing, we know that these are stressful times. The constant barrage of negative news headlines and shrill bleating masquerading as investment advice emanating from some of the financial news networks can exert a powerful emotional force on the decision making process. To the extent possible, this should be resisted. The market is there to serve you and not to guide you. Falling under its manic-depressive spell is not conducive to long- term investment success. A rational approach, taking advantage of the opportunities presented by lower prices on a case by case basis seems to us the better course of action.