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On many occasions during the past year, I've seen and heard the past 10 years dubbed as "The Lost Decade." From a stock market perspective--with prices essentially flat between 2000 and 2010--it's not hard to understand why. Upon writing this article, the annualized return on the S&P 500 over the past 10 years was -0.68 percent, versus the average return of 6.28 percent since 1929 (according to FactSet Data Systems). Interestingly, over a similar time frame, aggregate corporate profits have doubled while total household net worth is about 50 percent higher.
While the stock market seems to say we've made no progress, economic statistics indicate otherwise. So why the disparity? For a better understanding, enter our lessons learned from the past decade.
• Lesson 1: Starting point/valuations matter. By the end of 2000, the S&P 500 was coming off a five-year period in which it had advanced, on average, 25 percent per year. The price-to-earnings ratio stood at over 30x--the highest on record and several standard deviations above the norm. These levels were attained after a decade that had experienced only nine months of recession and no stock market correction that lasted more than three months. From a market perspective, the decade that ensued was not a reflection of lousy economics as much as it was inflated starting valuations.
• Lesson 2: Leverage matters. In all parts of the financial system, leverage (debt) grew throughout the last two-plus decades. The escalation actually began in the 1980s with dramatically declining interest rates, easier lending standards, and changing tax laws that encouraged spending and credit. Leverage is exhilarating in growing markets because it magnifies the upside. However, problems become apparent when asset values stop appreciating. The situation obviously becomes intensely magnified when those values depreciate as rapidly as they have in the past decade.