How Long Can Stocks Underperform?

The S&P 500 is now roughly 8.5% off its all-time highs last month, foreign stocks are getting hammered, and the crypto markets saw over $1 billion in liquidations over the past weekend. What is causing this selloff? There is no single culprit, but a mix of weakening economic data, Warren Buffett selling half his Apple stock, and the Japanese Central Bank raising interest rates are to blame.

The VIX, a measure of market volatility, traded above 65, which is the third highest reading after March 2020 and the 2008 financial crisis. Betting markets are now pricing in an 18% chance that the Fed does an emergency rate cut this year. A lot is happening very quickly and I can understand why it can feel a bit scary. As the saying goes:

There are decades where nothing happens and there are weeks where decades happen.

This may be one of those weeks where decades happen.

But let me provide another perspective. I’ve been writing on stocks and markets for the last 8 years and I’ve seen selloffs of varying degrees over this time period. If you don’t pay attention to markets, selloffs can feel scary because you don’t see them very often. Just look at how many mainstream financial services were down yesterday morning as investors checked their accounts:

But, if you are always watching markets, you start to get desensitized to them. Every time the market sells off a little and everyone starts panicking, I get the same thought, “This again?”

How many times have I been through this? How many times have I felt compelled to comment on a selloff that didn’t end making any real difference in a year’s time?  Of course, maybe this selloff is different. 2020 definitely was. And this one has some of the makings to be something bigger. But how much will this impact us in 10 years’ time? In 20 years’ time? Probably little, if at all.

I’m not saying that we should put our heads in the sand and say “none of this matters.” It could matter, but it might not. For many investors, the time when it matters is when it leads to poor long-term performance. That’s ultimately what we fear. But, how often does this happen? In other words, how long can stocks underperform?

That’s the question I want to address today.

Recently, Corey Hoffstein brought my attention to a paper that argued that the real (i.e. inflation-adjusted) long-term return of non-US stocks wasn’t 6.6% (as estimated by Jeremy Siegel in Stocks for the Long Run), but only 4.4%. Siegel addressed this by stating:

If we include the McQuarrie adjustment, real stock returns from 1802 through 2021 are reduced from 6.9 percent per year to 6.4 percent over the 220-year period and do not affect any data over the last 187 years.

So while returns are a bit lower with this new data, they don’t make me believe any less in the long-term growth of global equities. However, there was another point made by this paper that I did agree with.

The paper argued that the historical returns of the U.S. stock market don’t generalize to other equity markets around the world. In other words, the performance of U.S. stocks is an outlier and we shouldn’t expect to see similar performance elsewhere. Some evidence for this included a list of the worst multi-decade returns experienced by non-U.S. equity markets over the past century:

As you can see, there are many 20-year and 30-year periods where individual equity markets experienced negative real returns.

While the U.S. has never experienced a 20-year period of negative real returns, it has gotten close a few times. From February 1966 through December 1982, U.S. stocks lost 0.16% on an annualized basis, when including dividends and adjusting for inflation. That’s a 16-year period of negative real returns. Additionally, from September 1929 through December 1944, U.S. stocks experienced a 15-year period of negative real returns. This coincided with the beginning of the Great Depression through WWII.

The United States has definitely been an outlier on the global equity stage. This is why I don’t expect global equities to return 7% per year after-inflation, but closer to 4%-5% per year after inflation. More importantly, I don’t expect global stocks to only experience a 15 or 16-year period of negative real returns. History says that real returns can be negative for a bit longer.

As the chart below from UBS illustrates, some markets have much longer periods of negative real returns for both equities and bonds:

As you can see, at their worst many equity markets experienced 25 or more years of negative real returns. Would I ever expect something like that to happen to the U.S. or for World stocks as whole? Not really.

My reasoning is simple—diversification. Many of the equity markets shown above do not have the level of diversification that the U.S. or the World (as a whole) has. For example, Norway’s stock market is very dependent on the oil & gas sector. Germany’s stock market is reliant on its automotive and industrial sectors. And so forth.

So, when you see that an individual country had a multi-decade period of poor returns, it is very likely that this can be explained by a handful of companies with poor performance or poor performance of one sector. This is why individual country equity performance is not really comparable to U.S. equity performance or World equity performance. Because most individual countries aren’t diversified!

This is my primary issue with the country-level equity performance data I’ve shown here. By examining equity performance by country, you make it seem as if each country is equally important to global equity returns. But we know this isn’t true. Ireland has a population of 5 million people. There are almost 4x as many people in the New York City Metro area. The fact that Ireland and the U.S. are equally represented in the chart above tells you nothing about global equity performance.

So as much as I want to warn you about the dangers of equities based on individual country level performance, the dangers are clearly exaggerated. You can see this by looking at the “World” bar in the chart above which shows a 22-year period of negative real returns.

Yes, this isn’t great, however, it’s also slightly misleading. Not only does it cherry-pick the worst 22-year period in the historical data, but it also assumes that you only invest one time and then never again. But, as I’ve highlighted many times before, no one invests like that!

If you are buying over time, you will likely experience a better performance than any of the cherry-picked snapshots highlighted above. In addition, by buying over time you can offset any losses through your additional contributions. While this won’t work indefinitely, adding money over time softens the blow.

Lastly, as dismal as some of these individual country equity performances have been, many of them still beat inflation over time. I know that keeping pace with inflation isn’t the reason we buy equities, but if that is the worst case scenario in the long run, then sign me up.

So how long can stocks (as a whole) underperform? The data suggests a few decades in the worst scenarios. Are we at the beginning of one such period now? I doubt it. If we are, then you better buckle up and Just Keep Buying.

Happy investing and thank you for reading.

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