In this case, the lemon happens to be the miserable returns the stock market has generated for your portfolio, not only during the past 12 months, but over the previous decade.
Common stocks are on track to produce the second worst year on record.
One can easily identify the unfolding financial crisis and economic recession as a primary culprit for this past year’s steep decline in common stocks. But is there anything to point to as a cause for such a dismal 10-year number? Let’s take a closer look at the dynamics of the stock market, and in our discovery we might find the makings of our lemonade.
As any investor will tell you, predicting the short-term swings in the stock market is more akin to gambling. Over the course of a year or three, the fickle stock market has a mind of its own.
But there is an indicator that gives us a clue as to the returns the stock market might generate over a longer period, of say, 10 years or more, and it happens to be a fairly simple one – the stock market’s valuation at the beginning of the time period. For instance, if the stock market has a high valuation (circa 1998, and a price/earnings ratio of 35), future returns tend to be rather subdued (if not negative).
On the flip side, if the stock market has a low valuation (circa 1982), future returns tend be considerably higher than the market’s long-term average of 10 percent. This phenomenon is based largely on the amount an investor pays for a dollar earned by a company. In short, if you pay less, you get more.
Because of the significant decline in common stocks in 2008, that is exactly where we are today; valuations on equities are as cheap as they have been over the past two decades, if not approaching the levels of 1982.
The lemonade in this scenario is that because of the current valuations, the stock market is presenting us with an exceptional opportunity to capture returns over the next decade that are likely to be (a lot) higher than long-term averages of 10 percent.
If you are intent on capturing these returns over the next decade, two notes of caution: First, it won’t be a smooth ride. Your common stock portfolio is likely to experience big bear markets and big bull markets, not unlike the volatility seen in the 1980s and the past 10 years.
Second, if you are going to subject your common stock holdings to that kind of volatility, make darn sure you are rewarded for it. How can you do that? Stay tuned for your Coffeehouse New Year’s resolution.
