The bright side of stocks' dismal decade

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It's not just the past few days that have been hard on stock market investors. It's the past decade.

Around the world, major stock market indexes are at levels they first hit 10 to 15 years ago – or in the case of Japan, almost 30 years ago. Despite substantial economic growth since then, stock prices have not managed to put together a sustainable advance.

Many investors may look at that dismal track record and resolve to never again put their money into anything riskier than a bank account. But there's a more optimistic way to view the evidence. According to some market strategists, the long stagnation has left stocks looking like much better values than they were a decade ago.

Some of the lessons that emerge from this age of investor frustration:

Rough patches can last a long time. Canada's benchmark stock index first climbed to today's levels in the summer of 2000. It has spent the past 11 years rising and falling, but producing no net advance in share prices.

Japan's Nikkei 225 stock average reached its current levels in 1983, then went on to test the patience of shareholders for the next generation. The Nikkei is still about 80 per cent below its peak in 1989.

Dividends matter. While major stock market indexes have gone nowhere for years, patient investors have still managed to eke out gains by collecting dividends. In Canada and the United States, dividends put about 2 per cent a year in the wallets of investors who held the broad index, while in Britain, dividends rewarded shareholders with about 4-per-cent-a-year returns.

Valuation is key. The past 25 years show that buying stocks when they're expensive nearly always ends badly. At the peak of the Japanese stock market bubble in 1989, the price-to-earnings ratio of the Nikkei index hit nearly 70 – a ratio that was wildly out of whack with more normal P/E ratios of 12 to 15.

In the U.S., at the top of the dot-com bubble in the late 1990s, investors drunk with optimism about the Internet pushed the price of the blue-chip S&P 500 index to more than 30 times earnings in July, 1999, while the P/E ratio of Canada's benchmark S&P/TSX surged to almost 40 around the same time.

In each of those cases, the nose-bleed valuations left stocks vulnerable to disappointment – and, sure enough, that disappointment unfolded over the years to come.

Popularity kills. At the height of the technology bubble in the late 1990s, few people would have correctly predicted that those who invested in the decidedly unpopular areas of gold and government debt would reap big returns over the decade to come.

The dismal returns of stocks since the dot-com heyday, and the substantial profits from gold and government bonds during that period, suggest a fundamental truth: The best returns usually come from buying investments that are out of favour.

"The worst times to buy stocks were when things looked the best," said William Bernstein, author of The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between. "The time to sell [them]is when everybody is telling you that [they]ought to be in your portfolio."

Right now, the picture is nearly the reverse of what it was at the height of the tech bubble. The P/Es for the benchmark U.S. and Canadian equity indexes are less than half their peak levels. Meanwhile, the yields on 10-year government bonds have tumbled from over 5 per cent to around 2 per cent.

While stocks could certainly fall further, especially if Europe's debt crisis morphs into full-blown disaster, they are now looking far more attractive than they did a decade ago – precisely because they are no longer so popular.

"You don't invest by looking out the rear-view mirror, you invest by looking out the front windshield," Mr. Bernstein said. "It's foggy, but you can still make out whether it's dark or light out. The expected returns on stocks are clearly higher than the expected returns on bonds right now."

The long, long dip

Sometimes the market bounces back quickly after a fall – but sometimes it doesn't.

Source: Bloomberg, Merrill Lynch