Stock Market Perspective

The Good, The Bad and The Ugly

The stock market has generated substantial returns over the last 30+ years. So few would argue that the stock market has and continues to be the investment of choice for long-term investors. This months Investor Notes will serve to provide some perspective on performance of the S&P 500 Index as we review the good, the bad, and the ugly associated with the stock market.

Perspective Overview:

• The GOOD: The stock market has generated phenomenal long-term results and therefore will remain the corner stone investment in most portfolios.
  
  
• The BAD: These impressive returns however, have experienced intermittent periods of flat to negative performance.
  
  
• The UGLY: In some instances the stock market has had to endure extreme periods of loss both in magnitude and duration.
  
  

The CONCLUSION: All investments whether they are stock, bond or futures orientated have experienced periods of poor performance. In most cases and over the long-term they have been able to fully recover to produce above average returns.

The Good

We begin with the undisputed fact that the S&P 500 Index produced a total return of 1,100% from the early 70's through the 1st quarter of 2004. Impressive results given that this test period includes a number of cyclical bear markets. Table 1 below provides an itemized list of the S&P's performance through the decades. No matter what long-term time frame is evaluated the historic performance has been extremely good.

Point of Fact: It is interesting to note how the annual rate-of-return (AROR) has changed over the decades. The "experts" often quote historical returns for the stock market in the 10 - 15% range. Although this may be true during the secular bull market phase through the 80's and 90's, the more realistic historical return figure is closer to 8%.

If investors are to participate in the returns of the stock market they must follow a long-term time horizon. Essentially they should find an investment that is capable of actively trading the stock market and remain with the investment through thick and thin. Investors should avoid jumping from product to product chasing performance. In the end all good things come to he who waits.

Table 1: Historical Performance Results

The chart below graphically illustrates the performance of the S&P 500 over the past 30+ years. The chart begins with the tail end of the 1966 - 1982 secular bear market, which in turn leads to the 1982 - 1999 secular bull market and it concludes with the newly formed cyclical/secular bear market still in effect today.

Chart 1: S&P 500 Index Equity Curve (Log Scale)

The Bad

Despite the phenomenal long-term performance of the stock market there have been periods of poor performance. Table 2 reviews a wide variety of rolling periods, ranging from 6 months to seven years (84 months). Rolling returns are useful for examining the behavior of returns for holding periods similar to those actually experienced by investors. A quick review of these historic rolling periods provides investors with the best, worst and most recent performance results.

Point of Fact: Notice that the best 60 month investment period for the S&P 500 generated a total return of almost 220%, while the worst 60 month period produced a total loss of 23%. As with any investment you have to take the good with the bad.

Every investor wants to buy low and sell high to maximize returns. Unfortunately in the real world, investors are more likely to invest closer to the worst time then they are the best time. Why? Because of human nature. Investors typically need to see good performance prior to making their initial investment. The more time it takes to make the decision the more likely the investment will be made at the worst entry point rather then the best entry point.

Table 2: Rolling Period Analysis

S&P 500 Index Rolling Period Analysis Jan/71 -- Apr/04
Months	Best	Worst	Latest
6	38.84%	-32.45%	5.39%
12	52.90%	-41.46%	20.77%
18	61.83%	-43.06%	25.02%
24	76.80%	-43.24%	2.83%
36	120.01%	-43.39%	-11.36%
48	172.02%	-34.07%	-23.75%
60	219.83%	-23.11%	-17.07%
72	236.06%	-18.88%	-0.41%
84	237.16%	-11.11%	38.17%

The 6 month rolling period graphic below illustrates the true volatility associated with the S&P 500 Index. As much as investors would like to believe that the stock market has gone straight up during the past 30+ years, it is abundantly clear from Charts 2 that there is a distinct ebb and flow to the performance of the S&P 500 Index. It should be noted that this volatility is very similar to a number of investments within stock, bond and managed futures industry.

Chart 2: S&P 500 Index Rolling Period Analysis (Six Months)

The Ugly

There are a number of ways to measure the risks associated with an investment. One of the risk evaluation tools used by Chart Research is Peak-to-Valley drawdown. Essentially Table 3 reviews the top ten worst drawdown periods (i.e. cyclical bear markets) experienced by the S&P Index since the early 70s.

Point of Fact: Within the recent past the S&P 500 Index experienced its worst drawdown period since the early 70s. At its worst point the S&P Index 500 was down 46.28%. As of April 2004 the S&P 500 Index had been in this drawdown period (i.e. secular bear) for a total of 44 months and counting.

The second worst Peak-to-Valley drawdown occurred in the S&P 500 during a cyclical bear market in late 1972. In total the S&P 500 Index was down 46.21% at its drawdown valley. Incredibly it took the S&P 500 Index a total of 91 months (i.e. ~7.5 years) to fully recover.

There are bear markets and then there are BEAR markets. How investors position their portfolios is vastly different when confronted with a cyclical bear versus a secular bear market. We have compiled a great deal of information to make the case that U.S. equity markets are now in a secular bear market and have been so since early 2000. The old long-term buy-and-hold strategy employed by many investors in the 80s and 90s is ill-equipped for the volatile and sideways action of a true secular bear market. Click here for the full story on bear markets.

Table 3: Drawdown Analysis

The underwater equity curve (Chart 3) analyzes a different aspect of performance then the traditional equity chart shown in (Chart 1). The underwater equity curve plots the downside risk exposure experienced by an investor over time. Unlike most equity curves, the underwater equity curve centers exclusively on equity drawdown. Specifically it focuses on the magnitude and duration of each drawdown, or sell off from peak levels.

Chart 3: S&P 500 Index Underwater Equity Curve

Underwater Equity Comparison

The table below outlines the Peak-to-Valley drawdowns for several major indices. The stock market is represented by the S&P 500 and Nasdaq indices. The other three assets classes in this underwater equity comparison include; bonds (Lehman Bond Index), Real Estate Investment Trusts (NAREIT) and managed futures (MAR index). The MAR index represents the cumulative performance of the managed futures industry. The time period used for this comparison spans the largest secular bull market in stocks from January 1980 through April 2004.

Point of Fact:

Notice the substantial historic drawdowns experienced by the stock indices versus the bond and managed futures indices. The top three drawdowns experienced by the two stock indices exceed the largest drawdowns for either the Lehman Bond or MAR indices. Measuring risk with the underwater equity curve allows investors to clearly note the risk associated with a particular investment.

Underwater Equity Comparison Top 3 Drawdowns per Index Jan/80 -- Apr/04
Rank	ROR	Peak	Valley	Full Recovery Period	Market
1.	-75.04%	Feb-02	Sep-02	50+	Nasdaq Index
2.	-46.28%	Aug-00	Sep-02	44+	S&P 500 Index
3.	-32.93%	Aug-87	Nov-87	24	Nasdaq Index
4.	-30.26%	Sep-89	Oct-90	18	Nasdaq Index
5.	-30.16%	Aug-87	Nov-87	23	S&P 500 Index
6.	-23.88%	Aug-89	Oct-90	20	NAREIT
7.	-23.80%	Nov-80	Jul-82	25	S&P 500 Index
8.	-23.74%	Dec-97	Nov-99	37	NAREIT
-- 20% Drawdown Cutoff --
9.	-17.90%	Jul-87	Oct-87	18	NAREIT
10.	-15.50%	Jul-89	Oct-89	9	MAR Index
11.	-15.01%	Jan-83	Jun-83	18	MAR Index
12.	-11.66%	Jan-81	Apr-81	5	MAR Index
13.	-8.99%	Jun-80	Sep-81	17	Lehman Bond
14.	-5.51%	Jan-94	Jun-94	13	Lehman Bond
15.	-4.89%	Feb-87	Sep-87	10	Lehman Bond