Note that we typically provide our commentary in two formats – this textual format, and a video/audio commentary. If you prefer the latter, it is available in the vlog section of our website. Also, we encourage you to pass this on to a friend.
Normally our commentaries focus on the next quarter ahead or review some sharp market movements that have recently occurred. This is an enjoyable exception – a chance to focus on long-term investing from the perspective of the upcoming new decade.
But to begin – a trivia question. The 2010s are notable for many reasons – one of them being the lack of a recession in the U.S. When was the last decade that the U.S. economy was recession free? You will get the answer after you read another 458 words.
State of U.S. Economy
Below is a table showing key economic and market indicators (as of December 12)*:
Consistency is good for capital markets. The continued strength of the economic data -- low inflation and interest rates, declining unemployment, steady if not spectacular GDP growth -- has been a constant drumbeat during most of the 2010s, and that evenness has certainly aided the capital market performance.
Past U.S. Stock Market Performance
While we get a variety of questions from readers and clients, over the last couple of years the most frequent has been something like “why should I invest in anything other than the S&P 500?” When we look at the graph of capital market returns during the 2010s below**, it’s easy to see the motivation of the question.
LC is Large Cap Stocks, Val is Large Cap Value Stocks, SC is Small Cap Stocks, RE is Real Estate, DI is Developed International Stocks, EM is Emerging Market Stocks, IB is Intermediate Bonds, SB, is Short-Term Bonds, Com is Commodities
Large capitalization stocks have been the best performing investment type (although not listed, large cap growth stocks have performed even better). Given the recency bias that drives most people’s beliefs, it’s logical to look at the past ten years and decide that you only need to invest in large caps.
However, I want to travel backwards in time – not too far, only a decade. If we look at the same graph showing returns from 2000 to 2009, we get a totally different picture.
The questions we were getting 10 years ago were “why should I invest in U.S. stocks at all?” In the first decade of the 2000’s, U.S. large cap stocks not only underperformed EVERY other asset class, they lost money (and that’s despite a 26% return in 2009). Emerging market stocks were the darling investment, also having performed very well in the 1990s.
What a difference a decade makes. Before looking at what the next decade will bring, we need to consider why the past two decades were so different. As a former academic, I’m tempted to go into a 20-page analysis of the various changes in production methods, federal reserve policy, and demographic trends. In this case, I can be brief because there is one overriding factor. The decade of the 2000’s ended with the worst recession in the past 80 years, and the 2010’s were recession free.
How unusual were the 2010’s? Let’s now answer the trivia question. Prior to this decade, the last time the U.S. economy enjoyed a recession free decade was … NEVER. In our entire 240-year economic history, we have had a recession in every decade until the 2010’s. Even current pop star and first Treasury Secretary Alexander Hamilton was not immune from presiding over an economic downturn.
If you believe you should invest in 100% U.S. large cap stocks solely because of the recent capital market results, you are essentially betting that the 2020’s will also be recession free. While we don’t see an imminent recession, 10 years is a long time, and we would advise against such a bet. Our belief is that the 20’s will be somewhere in between the 00’s and the 10’s. And such a belief is consistent with recommending diversification into other asset classes.
Another reason to diversify is the potential for economic instability. The economy has been very stable over the past ten years, and there is little evidence that instability will occur soon. But we know that in most cases economic instability comes out of nowhere and wasn’t foreseen two to three years prior – consider the debt crisis of 2008, the internet bubble of 2000, or the still unexplainable 20% decline in stocks on a single day in 1987. During such instability, investments in asset classes such as value stocks, international stocks, and, of course, bonds, dampens the volatility of a portfolio.
Two basic tenets of our investing philosophy
I’ll conclude by stating two basic tenets of our investment philosophy. At this point one might think our focus on the decade of the 00’s would lead us to be completely out of large cap stocks – that is definitely not the case. The 00’s need to be considered, but only as part of a long-term investing history. Our first tenet is that the single largest equity asset class be large cap stocks – indeed we have strong feelings about other portfolios we have seen that invest most of the capital in mid and small cap stocks or international stocks. While those investments should be diversifiers, having them constitute the majority of a portfolio is the tail wagging the dog. The second tenet might be more obvious but is worth stating. Stocks over the long run (including the next decade), should outperform bonds, but will also have greater volatility – meaning the choice between stocks and bonds is the classic return versus risk tradeoff. The right level of that tradeoff is unique for each investor, and one we strive to achieve.
* Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board, Standard and Poors
** Source of returns is Morningstar, Inc. Past performance is not indicative of future results.
*** The National Bureau of Economic Research only tracks recessions back to 1845, but other studies go farther back