Note from Our CIO: The Inevitable

March 9^th of this year marked the sixth anniversary of the worst U.S. stock market crash since the Great Depression. On that challenging day in 2009, the S&P stock index of the largest 500 U.S. companies closed at 676.53, or 57% lower than its previous all-time high exactly 17 months earlier.

Why did the decline end that day? Ultimately, it was because the low stock prices and the resulting higher dividend yields became too compelling for investors, especially given the alternative of low yielding bonds.

As I write, the S&P 500 is closing in on 2,100, which means that it has tripled in value in six years. This ignores the additional return from dividends, and it is in spite of a 19% drop in 2011 (remember the trifecta of a U.S. debt downgrade, threat of a U.S. government shutdown and fears of an imploding euro currency?).

So why am I giving you the Cliff’s Notes version of the last six years? Because all of us at Abacus want to remind you that another bear market is inevitable. But we need not be fearful of it.

In the 70 years since World War II, there have been 14 bear markets in which the S&P 500 dropped from 19% to 57%. This means that every five years on average, portfolios invested exclusively in the largest 500 U.S. companies shed one-third (or 33%) of their value. Despite these roller-coaster drops, $1,000 invested in the stocks of the largest U.S. companies (with dividends reinvested) at the end of World War II would be worth well over $1,000,000 today. If you want to call that the “miracle of free markets,” then I won’t stop you.

So, based on this simple model of a bear market happening every five years on average, with the last one in 2011, we can conclude that we are due for another in 2016. However, these are just averages. As the chart below shows, the Dow Jones Industrial Average (which is similar enough to the S&P 500 for our purposes here) is up 172.7% since March 9, 2009, which is a far cry from the rallies in the 1990s and 1950s that were north of 350%.

Source: WSJ Market Data Group

Now, this will make me sound schizophrenic: First I’m preparing you for a bear market; now I’m going to suggest that the current bull market might still have legs. In fact, one can argue further that we are not yet even in a true bull market. The current prices of stocks relative to their earnings are not remotely near their levels in 2000 at the peak of the dot-com bubble. Furthermore, as the chart below shows, the 8.0% annual performance of the S&P 500 over the past 10 years through July 2014 ranks in the bottom 30% of all 10-year periods for the index since 1928—hardly an impressive bull market.

So will the current rise in stocks end tomorrow, in one year or in ten years? I don’t know, and it doesn’t matter. What is important is this:

1. We can’t at any time during the supposed bull market buy into the idea that we are in a new paradigm (think Internet craze of the late 1990s or the belief that real estate can only go up in the mid-2000s) because if we do, even slightly, then we will be caught surprised when the next bear market hits and that much less able to cope emotionally with it.
2. When the next bear market hits (not if, but when), what will we think is going on? Will we think, “This time is different,” which have proven 14 times since World War II to be the four most dangerous words in investing? Or “Prices will take too long to recover given my age”? If so, we will panic out of the portfolio, and that will most likely be a tragic mistake.

Bear markets are an organic part of the financial system. They are the reason that the value of the S&P 500 companies have grown 1,000 times in the past 70 years. We can’t have one without the other. It’s a package deal. Volatility and stock performance—each is inextricably intertwined with the other.

In fact, Abacus client portfolios are well prepared for bear markets to the extent that in about seven to 10 years, a bear market can be an opportunity for our clients still saving (or not withdrawing yet) to buy stocks at lower prices as well as an opportunity for our withdrawing clients to sell some of their bonds to buy stocks at lower prices. The key shift in thinking here is from fear to opportunity, or at least to confidence in a disciplined, time-tested system. It is not an easy shift, but your advisor at Abacus would love to continue helping you understand it and stick to it.