This article is a guest contribution by Bill Hester, CFA, Hussman Funds
Can the process of forecasting long-term stock market returns be simplified to include just one step ā calculating the prior decade's return? This is one of the arguments that analysts are currently using to convince investors that the coming decade will offer above-average returns. It's important to take a closer look at the argument because it's become widely discussed and reported. A strategist at a major investment bank argued recently that poor 10-year trailing returns is reason enough to expect lofty returns over the next decade. A similar argument was recently made in Barron's, and by various mutual fund companies.
Some of the research is structurally flawed. One piece examines the 50 worst 10-year returns since 1871 to construct a sample to calculate subsequent 10-year returns. The study used monthly data, so many of the observations clustered within a single year. 11 of those "worst" returns occurred during the past decade. Of the remaining 39 months for which the subsequent 10-year stretch of returns is known, 32 of them occurred around 1920, so the study is heavily influenced by a single period. The implicit argument is that the next decade will look much like the Roaring 1920's.
But even using a broader set of periods with poor trailing returns, the average return during the decade that followed has typically been slightly above average. In fact, some of the individual periods have provided strong returns, especially when they marked the beginning of secular bull markets, like in 1942 and the early 1980's. The graph below shows the 10-year rolling total return of stocks since 1929.
Looking at the graph, it is clear that 10-year returns for the market have varied a great deal, creating long "secular" periods of above-average and below-average returns. There are just few periods where 10-year trailing returns fell to very low levels ā after the stock market crash of the early 1930's, in the early 1940's, and again during the late 1970's and the early 1980's (on an inflation-adjusted basis, the 10-year returns during these last two periods were also negative). A cyclical bull market followed the low returns of 1933, and secular bull markets followed the low returns of the early 1940's and early 1980's. When looking at the data below, we'll include the 100 worst months of 10-year trailing total returns beginning in 1929. This group of months will capture the bulk of the periods just mentioned.
The Drivers of Returns
Once the observation is made that long periods of negative trailing returns have been followed by strong subsequent returns, it's logical to ask whether there are other characteristics that those strong decades shared. To that end, it makes sense to begin with the fundamental underpinnings of stock prices: growth and valuations.
