The upside of down markets

If you're an investor of a certain age -- less than, say, 45 years old -- you can be forgiven for feeling a bit jaded. You entered the workforce when the clock was just about to strike midnight on the great bull market ball of the 1980s and 1990s, turning internet millionaires into pumpkins and mice. And even if you were able to catch a few years' worth of double-digit stock market returns, the likelihood is that your portfolio was so small that the impact was rather minimal, in dollar terms.

Bonds? Yes, they started a nice long bull market run in the 1980s too; one that you largely missed. It's unlikely we'll see its ilk again anytime soon unless the Fed can figure out an interest rate that's lower than zero.

Housing? How's that working out? Your parents bought a nice place they could afford, watched its value increase slowly and steadily over the years, and when it came time for them to retire they discovered that they were sitting on a nice little boost to their nest egg. You, on the other hand, struggled to find a place you could afford that could hold your growing family. Perhaps you ended up spending a bit more than you would have liked, but when's the last time we saw a bear market in house prices? So much for that theory.

So as you enter your prime earning years, the 15 year return on the stock market is barely half its long-term average (to say nothing of its five- and ten-year return). That return, in fact, trails the return provided by bonds, those same bonds that conventional wisdom said you didn't need to pay much attention to 15 years ago, what with your long time horizon and all. And (just a hunch) it seems unlikely that the housing market will provide the same boost to your bottom line over the coming years that previous generations enjoyed.

Gloomy enough? Now for some good news.

Your mother was right: it is always darkest before the dawn -- particularly in the stock market. Think back to the start of the bull market in 1982, when the price/earnings ratio on the S&P 500 was about seven -- less than half its long-term average -- and its dividend yield was some seven percent. Stocks were a screaming bargain, right? Well sure -- in hindsight.

But no one wanted to own stocks then. Their total return over the previous 15 years had been -5 percent. Interest rates were in the mid- to high-teens; money markets were yielding over 10 percent. Business Week famously announced, just a few years earlier, the "Death of Equities," claiming that the only people who still owned the wretched investment class were the elderly and folks who didn't know any better.

The long-term bull market that was about to take off, in other words, was far from apparent for most investors in those days. Gloom prevailed. Just as it does today.

I remember an older colleague telling me, in the midst of the bear market of the early 2000s, that true bear markets don't end with investors eagerly trying to guess when it was safe to re-enter the market. Rather, they end with the proverbial blood on the streets.

Well, if you haven't noticed, the blood has been spilling. Since 2007, investors have pulled more than $300 billion out of equity mutual funds, and there are nearly 300 fewer stock funds today than there were at the end of 2008; fewer, even, than there were in 2003, when the previous bear market ended.

As a front page article in the Wall Street Journal described it a few weeks ago, "investors are abandoning the time-tested 'stocks for the long run' optimism that dominated since the late 1980s."

And who can blame them? With a double-dip recession looming, a European economic crisis whose effects promise to be large and unpredictable looking more likely by the day, and the fundamental inability of our nation's leaders to provide the leadership we so desperately need, there's no doubt that there's ample reason to lose one's faith in the rationale for owning equities.

But before you succumb,revisit some of the math I presented a few weeks ago. At current valuations, it seems reasonable to expect stocks to provide an annual return of somewhere around 8 percent or so over the coming decade. Not compelling enough?

Consider that at that level, the equity risk premium (the amount by which stocks outperform risk-free Treasury bills) would be about 7.5 percent (thanks to short-term rates that are essentially zero). That's higher than the risk premium an investor in 1982 would have expected, and likely one of the higher risk premiums we've seen for quite some time.

Does this mean that stocks are on the precipice of another two-decade run of returns averaging 16 or 17 percent?

I wouldn't hold my breath. It's not even to suggest that we aren't faced with another few years' worth of negative stock market returns. But this simple math -- along with investors' well-documented tendency to do precisely the wrong thing at precisely the wrong time -- indicates that stocks are starting to offer a pretty compelling value proposition.

Successful investing is all about putting the odds in your favor. Keep costs low; diversify broadly; keep an eye on the long-term; and by all means don't make the mistake of thinking you know more than the market does. But that last admonition doesn't mean that you can't use a little common sense to set your long-term expectations.

And in doing so today, there seems to be good reason for an entire generation of investors who have spent years being in the wrong place in the wrong time to have hope that their patience and faith will at long last be rewarded.