The Lost Decade

A Map and Compass for the Investment Wilderness

The S&P 500 is no higher now than it was in April of 1999. That's nine years of aimless wandering for the world's best-known and most-owned index. This sobering statistic was the foundation for The Wall Street Journal's front page article, "Stocks Tarnished by 'Lost Decade'...Credit Crunch Could Prolong Weakness" (by Jim Browning, March 26, 2008). The piece was one of the most read and most blogged articles on the web that day. And no wonder — even skeptical investors would expect to see positive returns over that long a stretch. Let's take a deeper look at this story and see what investors can do to avoid that lost feeling.

What is a lost decade?
Let's start with the idea of the lost decade itself. To be sure, an investor who bought The S&P 500 in April 1999 has little gain to show for it. The index is now in the high 1300's, right where it was 1999. Dividends earned would bump up the return a bit, but inflation would undo most of that. It really has been a flat nine years for the S&P.

Now there's a reason Mr. Browning deemed nine years to be a decade. Going back one more year to March 1998, the index was at 1100, which dilutes the "lost" argument — but only marginally. Go back just one more month to February 1998, and you'd find the S&P at 1000. From there, go back less than three years to March 1995 and you'd be buying the S&P at 500. (wikipedia)

So the nine-year decade really has been lost for that index. On the other hand, if you use an equally arbitrary 13-year decade, the S&P has nearly tripled.

But Mr. Browning is dead right, nine years is a very long time to see no significant return. As he describes, "Conventional stock market wisdom holds that if investors buy a broad range of stocks and hold them, they will do better than they would in other investments. But that rule hasn't held up for stocks bought in the late 1990s or 2000."

Faulty compass
If there is a flaw in Mr. Browning's premise, it is the idea of the S&P 500 as a broad range of stocks. Yes, the S&P is big, but it is really not very diverse. All of its components are large cap US stocks. Because they are more similar than not, stocks within it tend to move in the same direction in reaction to economic and market conditions. And that is by design — it is an index meant to capture the performance of that particular asset class, not to represent all flavors of the worldwide equity markets.

Any investor who relies strictly on the S&P (or any other single asset class) is much more susceptible to lost decades...as well as euphoric periods like the late 1990s, and periods of agonizing declines. Single asset classes are, on average, simply more prone to extremes than more diversified portfolios, and a nine-year period of no gain or loss is one such extreme. Because of its narrow construction, using the S&P 500 to avoid getting lost is similar to using a compass that only points east and northeast to find one's way in the fog.

And let's not single out the S&P. The world's second largest equity market, Japan, has been in a funk for 18 years now. At Nikkei approximately 13,000 today, it hasn't been any where near its high of 39,857 on December 29, 1989. Talk about a lost feeling!

Large markets and sectors do get lost from time to time. Before its recent ascent, gold went nowhere for 20 years, and only recently passed its 1980 high of $800. Oil was flat at $20 per barrel from 1985 to 2000. Big US stocks — the so-called 'nifty fifty' had an awful decade in the 70's. It happens.

By the same token, during frustrating periods when some asset classes can't find their way out of a cul-de-sac, others are likely rolling along just fine. During the nine-year decade described above, Treasuries are up 4.7% per year after inflation. An index of commodities has performed about twice as well, as have real estate trusts. Small US stocks outperformed the S&P by approximately 400%. And developing country stocks did even better. (Browning article)

Unfold the whole map
So how well does the S&P 500 represent the investment universe? Its market cap, at approximately $11 trillion, is about two-thirds of the total US stock market. Meanwhile, the value of all stocks worldwide is around $63 trillion. As such, the S&P is only about 17% of the total equity market. Total US debt — defined as the sum of federal, state, local, business, and private — is $53 trillion. Commodities, real estate and foreign exchange are trillions more. Taking a total market view, the S&P is an important cog, not the whole machine.

As a strong proponent of efficient markets and indexing, Osbon Capital Management builds portfolios that seek to replicate the composition and return of the total market. Large cap US stocks like those in the S&P 500 are part of the equation. Smaller US stocks, stocks from other economies around the world, debt instruments and alternative investments are just as important when creating a truly diverse portfolio. (As an aside, we never use the S&P itself as we find its weighting mechanism and buy/sell rules to be inefficient; see our article "How to Index.")

In our view, disciplined asset allocation is critical for limiting the probability of a real lost decade, where total portfolio return wallows for extended periods. Think of using a comprehensive mix of the world's diverse asset classes as using the whole world map to reach one's desired destination. By contrast, a map that only reaches to Bangor will be of limited value on a trip to Bonn or Bangalore.

Now where?
Mr. Browning's article suggests another lost decade may be coming if the pundits are to be believed. Are they right, or not? I personally have no idea and am naturally skeptical of fortunetellers, seers, gurus, and dowsers.

Instead of trying to predict what the S&P 500 (or any other asset class) may do in the next nine, ten or thirteen years, OCM will continue to construct robust, globally diversified investment portfolios of stocks, bonds, and alternative investments reinforced with currency and inflation beneficiaries. In so doing, we seek to participate in all the good and bad that different markets have to offer, confident that over time, the goods will far outweigh the bads.

We don't try to predict where the markets are going. We focus on where we are and staying pointed in the right direction. Every portfolio tells its own story through numbers — allocation, risk and return. We think monitoring your own portfolio GPS is the best way to avoid a lost decade. In the meantime, you may want to view what we pack as we travel the investment landscape. See the ETFs we have selected for their performance, risk and efficiency.

John Osbon, Chief Investment Officer
May 2008