After a spectacular first quarter, the U.S. stock market sputtered and gasped a bit over the past few months. But many people still seem to believe that U.S. stocks are all they need to create a secure and prosperous future.

Have we reached a "new era" for investors? Are the old rules of diversification and risk management suddenly out of date? Is a Standard & Poor’s Index fund really all you need to achieve wealth?

The evidence looks impressive, with 10 years of history apparently backing up the notion that nirvana has finally arrived for investors in the U.S. markets. It’s possible, in fact, that indeed we have reached nirvana.

However, I’d like to speak bluntly for a moment. For centuries, it has been known that fear and greed are the two most powerful forces that govern financial transactions. But in the 1990s, the unusually high returns seem to have put fear on the back burner.

Frankly, I don’t buy the notion of a new era for investors. I hope I am wrong. I hope that returns of 15 to 20 percent a year become commonplace with little or no risk. I’ll confess I would like to see a world in which everyone’s financial needs are fully met. But I believe in letting the past be my guide, so I decided to consult the history books.

Large-cap nirvana

For the past decade, from 1988 through 1997, the Standard & Poor’s 500 Index has appreciated at a rate of 14.5 percent, after adjusting for inflation. That return is generous enough to make many people’s dreams come true. Over a decade, that’s nearly enough to quadruple the real purchasing power (before taxes) of the original investment. That feels like a new era to many people, and in fact there are not many decades in this century that produced returns like that.

Four times since 1926, the Standard & Poor’s 500 Index, representing large U.S. stocks, has compounded at a rate higher than 14.5 percent for 10 years. The end of each of these decades (all of which overlap and include some of the same highly profitable years) must have also seemed like the dawn of a new era. So it may be instructive to see what happened.

For this discussion, we will define a "new era" as a period of 10 or more calendar years that produced inflation-adjusted returns of 14.5 percent or more. In Table 1 we show the results of the previous four new eras of the Standard & Poor’s 500 Index, along with what happened in subsequent periods.

As you will see, only one of those new eras lasted even two years after the first decade. Two others quickly degenerated into single-digit returns of the type that would be quite disillusioning to investors who thought they could count on the stock market for a ticket to Easy Street. The fourth new era produced a loss over the subsequent two years.

Only one of the past new eras lasted for even four years. On average, these four periods appreciated at inflation-adjusted compound rates of return of 7.7 percent over the next two years, 11.2 percent over the next four years, 9.8 percent over the next five years, 9.3 percent over the next eight years and 8.3 percent over the next decade. By any historical standards, these are favorable returns. But they are not the returns that investors would expect in a "new era."

Small-cap nirvana

Savvy investors know that over long periods, small-cap stocks outperform big ones. So we looked for "new eras" in small-cap stocks, using the same threshold of 14.5 percent after-inflation returns sustained for a decade.

As you can see in Table 2, we found 15 previous periods that met that standard. (And by the way, the most recent 10-year period doesn’t qualify, as compound returns were only 12.8 percent from 1988 through 1997.)

Of those 15, only two lasted for even two years. Here’s why that’s important. Two full years of underperformance (to say nothing of losses) would probably disillusion most investors who bought these stocks thinking they had reached some "new era." In one case, as you’ll see, a "new era" could legitimately be declared, as small stocks returned 16.1 percent, after inflation, from 1933 through 1942 and 16.2 percent from 1943 through 1962.

But on average, these 15 new era periods for small stocks produced very unexciting subsequent performance. As you can see at the bottom of the table, on average they never again produced double-digit returns.

Nirvana for bond investors

However, true believers may cite a third U.S. asset class that has turned in performance that seems worthy of being called a new era: long-term government bonds, which appreciated at 8 percent, after inflation, from 1988 through 1997. It seems astonishing to discover that long-term government bonds previously did even better than that over six 10-year periods in this century.

But as you’ll see in Table 3, every one of those periods included some of the most recent 10 years. In records going back to 1926, there is no 10-year period starting before 1981 in which long-term government bonds returned 8 percent or more after inflation.

Some investors might conclude that we really have achieved a new era for investors in long-term government bonds. Wrong! In every case, these extraordinary bond returns were largely a product of a huge decline in interest rates. And as most investors know, bond prices move in the reverse direction of changes in interest rates.

The huge decline in interest rates from the early 1980s to the mid 1990s was a one-time event that could not be repeated unless interest rates went way up in the meantime. And if that happened, prices of existing bonds would fall. Therefore it’s a fallacy to conclude that the last decade of high returns from bonds signal some sort of "new deal" for investors. Anybody who invested in bonds now hoping to repeat that performance would most likely be in for a rude awakening.

Bonds can be a worthwhile part of a portfolio. But except in extraordinary circumstances like those of the recent past, they aren’t likely to provide much protection from inflation. Since 1926, there have been 63 rolling 10-year periods. In 33 of those periods, long-term government bonds had negative inflation-adjusted returns.

Conclusion:

A "new era" for investors is mostly wishful thinking. It’s true there is much to like about the investment outlook domestically and internationally. But investors who think the future will continue to look like the past 10 years are seeing life through rose-colored glasses. They are likely to be cruelly disillusioned in the near future when returns move closer to their historical norms and when we experience a bear market, which on average has meant a 30 percent loss.

 

 

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