Most people claim to invest for the long term. Warren Buffett famously waits for the "fat pitch" and only then takes a swing. But how long a view should the typical investor take?
I suggest looking backward - and forward - at least 10 years. I base this advice on The Great Reflation, an excellent book by Anthony Boeckh, president of Boeckh Investments and a former chairman of BCA Research (they're the people who put out the Bank Credit Analyst newsletter). In his book, Mr. Boeckh provides evidence that the stock market does indeed offer fat pitches if you take a long enough view.
He includes a striking chart that looks at the performance of the U.S. stock market over the last century. For each year, the chart shows the backward-looking return over the prior 10 years. It demonstrates that when the market's annualized, after-inflation return over the previous decade is greater than 15 per cent, the return for the following decade is likely to be zero or even less. In short, extended periods of high returns tend to be followed by a long stretch of disappointing results.
In contrast, when the market's annualized return over the previous decade is zero or less, the future decade is almost certain to provide annual real returns of at least 10 per cent. The moral here: Bad times come before good ones.
For example, in 1919, just after the end of the First World War, the market's backward-looking return over the prior decade was minus 5 per cent a year. But anyone who invested then would have enjoyed annual returns of about 18 per cent during the Roaring Twenties - until 1929, at which point the high returns of the decade that was just ending signalled dismal times ahead. And indeed, returns were negative over the next decade.
However, in 1941, during the depths of the Second World War, the market rallied, and the annualized return from that point onward was 10 per cent a year until the end of the 1940s, when the backward-looking 10-year return flattened temporarily to zero as the strong postwar rebound had a meaningful correction. This was again a buy sign. The end of the 1950s again saw the market's backward-looking return at more than 15 per cent a year. At which point, not surprisingly, returns began to decline.
Similarly, the end of the 1970s, with inflation and interest rates in double digits, saw negative backward-looking annualized returns, which, of course, augured the wonderful 1980s.
Is Mr. Boeckh's signal perfect? No. In 1975 the backward annualized return was negative, yet it took half a decade more before the market took off. At the end of the 1980s the backward return was about 13 per cent a year and yet the market kept roaring ahead. By 2001 the market showed an even higher backward return over the previous decade of 15 per cent a year. But this time the signal was true, and the next decade was dismal.
What about now? As of last year, the market's backward return over the prior decade was negative 5 per cent a year. Since then the market is up, so the backward annualized rate now is a few percentage points above zero.
No one knows how high the market can go, nor does anyone know whether more crashes and recessions are on the way. Probably there will be a few. But one thing that Mr. Boeckh's research suggests is that by 2020 the market will be much higher than it is now, most likely with an annualized return of at least 10 per cent a year. Which means that from a Dow around 12,450 today, we would see it at about 30,000 by then.
That's something to think about for those who have given up on equities. The decade ahead is likely to be better than you think.