How to Use the Past to Predict the Future
Studies show that the long term return for stocks is 10% per year. These figures are derived from historical figures for the Standard and Poor 500 or some such index going back to 1802 which is when the earliest data was gathered. Simply stated, stocks return 10% annually over the long term. Yet as of June 30th of this year, US stocks have actually underperformed U.S. Treasury bonds for the past five, 10, 15, 20, and 25 years. This brings amazing color to investing. The returns from the safest investments have been higher than the returns from actual businesses. This data would suggest that human ingenuity, productivity, and technical know-how are not enough to produce an asset of greater value, over time, than the basic interest rate guaranteed by the government!1
Since stocks yield 10% per year over the long term but have yielded much lower returns in recent years, how can we use this divergence to predict what might lie ahead? An examination of these historical returns can be a useful tool for gauging future investment decisions. We can use probabilities to help make decisions about the allocation of investments in order to get the highest return with the lowest risk. For example, after stocks advance at a rate substantially higher than the historical norm, such as in the late nineties, it follows that they are probably due to endure a period of sub-par returns. These below-average returns would produce a regression to the mean which would pull stock market returns down to their historical averages. Abnormally low returns, such as we have seen since 2000, increase the probability of above average returns in the years ahead. Therefore, we can conclude that stocks are likely to enjoy strong returns over the next several years.
Since the inception of Peregrine Asset Advisers in 2001, the S&P 500 has recorded a -1.59% return. Stock market returns are also negative over the past three and five years. The regression to the mean has happened. There is a high probability that returns for the next three, five, and eight year time frames will be above the normal (10%). Intuitively, it holds that the steeper the descent of the stock market such as in 2008, the higher the probability of a robust recovery.
Probability does not mean certainty and is not infallible. Using history as our guide and supported by the recent bounce in the stock market, the probability is high that the stock market will have strong year in 2009.
During the second quarter, the stock market recouped its losses from the first two months of the year. This recovery essentially ran from March through the beginning of May. The S&P 500 recorded its best quarter in over ten years, rising 15.9%. This gain is such a welcome relief from the battering of six consecutive quarterly declines that we have endured. Stocks haven’t made much headway since early May. The market seems like it is trying to find an equilibrium level. The S&P is basically unchanged for the year and the Dow Jones Average is still in negative territory. The NASDAQ is showing more sustained strength as it is up over 10% for the year.
Economic indicators do remain vastly mixed. Several banks have repaid their borrowed TARP funds. Selected business and commerce indicators are picking up. Oil prices have rebounded signaling stronger demand. On the other hand, unemployment seems destined to overshoot 10%. State and local governments face cash crises. Housing values are still declining. Through this recovery, it is only a matter of time, until the positive forces should begin to outweigh the negative. This is what stocks need to break out of this equilibrium.
Staying Ahead of the Curve (Part Three)
Investors have clearly shifted their priorities more towards making money rather than preserving capital and avoiding risk. The panic caused by the financial crisis is clearly waning. This fact does not diminish the importance for investors to stay ahead of the curve. All of the investment capital that came out of the stock market will need to find a home where it will earn a decent return. Where will that be? It is doubtful that it will be in real estate. Current interest rates on cash equivalents are very low with very little likelihood of increasing soon. Large public retirement funds are underfunded and must earn high returns in order to provide the necessary payouts promised to their pensioners. How will they do this without investing aggressively in the stock market? Investment managers and institutions with high cash levels will have to scramble to jump back into the market. For this reason, all investors need to be prepared for a stock market that performs better than general expectations.
Peregrine Returns and Strategy
While Peregrine Composite returns avoided the sizeable declines from the swoon in the stock market in the first quarter, our client returns trailed the market averages during the strong rebound for April and May. Our second quarter Equity Composite was only up 2.30%. Our Balanced Composite was actually marginally down for the second quarter due to our long term Treasury bond holdings. Long term interest rates continued to rise during the quarter which caused our bond vales to decline. For the year 2009, our Equity Composite is up 1.13% and our Balanced Composite is down -1.85%.
Despite positive signs, it is still difficult to conclusively point to vibrant industries in our economy. Stocks are actually doing much better than the economy might suggest. Leading stocks in most industry groups have all turned north. As long as the economy doesn’t disappoint drastically, the overall market could continue to advance throughout the upcoming quarter. Currently, we are using an investment selection approach that emphasizes the characteristics of individual companies rather than on a broad theme.
1 Source: Wall Street Journal 7-11-09
Past performance is no guarantee of future results. Investment management involves the possibility of losses. Significant general stock market moves up and down can influence the performance of client portfolios. Composite returns are based on client portfolios of over $100,000. Not all clients are included in the composites. All returns include the reinvestment of dividends. All returns are net of fees. Composite returns are derived from aggregated, time-weighted returns for clients of Peregrine Asset Advisers. Individual client returns can deviate from the composite returns. While Peregrine uses the S&P 500 as a benchmark, Peregrine does not attempt to mimic the structure of this index. Individual client portfolios vary. The number of securities held also varies per client.
Do you have questions or would you like to know more, contact Dan Botti.