2000 - 2009: Decade of Extremes

Posted on January 13, 2010 by David Laidlaw 

Across multiple markets, the decade that just ended was one of extreme highs followed by deep troughs.  In March of 2000 with stock valuations inflated from the Internet frenzy, the S&P 500 traded as high as 1527.  The market reached this peak from a low of about 102 in March of 1980 capping a 20 year run during which the market appreciated 15 times and produced compounded returns of 14.5% per annum. 

Similar exceptional bull markets occurred in the price of housing and commodity markets such as oil.  Fueled by very low interest rates, housing prices grew by over 12% a year increasing 2.5 times from 1998 to 2006 according to the Case Shiller Home Price Index.  The price of a barrel of oil increased at annual rate of 35% from $20 in January of 2002 to about $150 in July of 2008. 

The pricking of these bubbles produced sharp losses in all three markets.  Even given 2009’s 20%+ advance in common stocks, the S&P 500 lost about 1% per year over the past ten years to conclude the worst decade-long performance run since accurate records were first collected in 1927.  Common stocks and energy prices adjusted much more quickly due to their inherent liquidity.  The housing correction continues, albeit at a slower pace as inventories slowly decline. 

During the 2000s, investment success depended on the ability to maintain a defensive position and avoid exposure to the most overvalued markets.  Most aggressive investors and momentum players lost staggering amounts of wealth as each of the bubbles deflated quickly. 

While we believe that being defensive will play a role in the coming decade, fixed-income investing may become much less stable due to the continued threat of inflation and credit quality concerns on sovereign debt both here and abroad.  The economy emerged from recession at some point during the third quarter of this year, yet the Federal Reserve continues to expand the money supply.  At the same time, the Federal budget deficit is surging with the government spending about 85% more than it receives through its tax receipts ($4 trillion spending v. $2.15 Trillion in receipts according to Office of Budget and Management tables).  These deficit numbers exclude liabilities associated with government entities such as Fannie Mae and Freddie Mac (estimated at $5 trillion) and the much larger longer-term obligations involving Social Security and Medicare.  

Yields on Treasury Securities as of December 31st are as follows: 3 Month Bill: 0.06%; 1-Year Note: 0.44%; 5-Year Note: 2.67%; 10-Year Note: 3.83%.  While yields have increased with better employment readings over the past few weeks, the rates are still historically low in absolute terms.  We expect rates to continue to increase as rational investors demand higher returns on their money.  Higher government debt levels ensure a larger supply of bonds that will eventually lower prices and thus increase yields.  Last year, the United States Treasury sold roughly $2.1 Trillion in Notes.  This year, the issuance is expected to increase to $2.45 Trillion.  Given these expectations, we continue to invest heavily in Inflation Protected Securities and keep bond maturities short in the fixed-income portions of our clients’ portfolios so that we will be able to buy higher yielding bonds in the future. 

On the economic front, we expect muted growth since higher than average unemployment rates will limit overall demand.  However, corporate productivity continues to expand.  During the recession, businesses slashed their work forces and prodded their most productive employees to work longer and smarter.  These productivity gains have allowed the majority of enterprises to maintain their profits during the credit crunch and steep recession.  Solid profit margins should support the recent stock market gains even though valuations are not as attractive as they were earlier in the year.  We still view common stocks as the most attractive asset class versus bonds and cash, but do not expect that volatility will remain as tame as it has for the past nine months.  The market has risen since March without a correction and this pattern will most likely be broken in the coming year. 

The pricking of these bubbles produced sharp losses in all three markets.  Even given 2009’s 20%+ advance in common stocks, the S&P 500 lost about 1% per year over the past ten years to conclude the worst decade-long performance run since accurate records were first collected in 1927.  Common stocks and energy prices adjusted much more quickly due to their inherent liquidity.The housing correction continues, albeit at a slower pace as inventories slowly decline. 

During the 2000s, investment success depended on the ability to maintain a defensive position and avoid exposure to the most overvalued markets.  Most aggressive investors and momentum players lost staggering amounts of wealth as each of the bubbles deflated quickly. 

While we believe that being defensive will play a role in the coming decade, fixed-income investing may become much less stable due to the continued threat of inflation and credit quality concerns on sovereign debt both here and abroad.  The economy emerged from recession at some point during the third quarter of this year, yet the Federal Reserve continues to expand the money supply.  At the same time, the Federal budget deficit is surging with the government spending about 85% more than it receives through its tax receipts ($4 trillion spending v. $2.15 Trillion in receipts according to Office of Budget and Management tables).  These deficit numbers exclude liabilities associated with government entities such as Fannie Mae and Freddie Mac (estimated at $5 trillion) and the much larger longer-term obligations involving Social Security and Medicare.  

Yields on Treasury Securities as of December 31st are as follows: 3 Month Bill: 0.06%; 1-Year Note: 0.44%; 5-Year Note: 2.67%; 10-Year Note: 3.83%.  While yields have increased with better employment readings over the past few weeks, the rates are still historically low in absolute terms.  We expect rates to continue to increase as rational investors demand higher returns on their money.  Higher government debt levels ensure a larger supply of bonds that will eventually lower prices and thus increase yields.  Last year, the United States Treasury sold roughly $2.1 Trillion in Notes.  This year, the issuance is expected to increase to $2.45 Trillion.  Given these expectations, we continue to invest heavily in Inflation Protected Securities and keep bond maturities short in the fixed-income portions of our clients’ portfolios so that we will be able to buy higher yielding bonds in the future. 

On the economic front, we expect muted growth since higher than average unemployment rates will limit overall demand.  However, corporate productivity continues to expand.  During the recession, businesses slashed their work forces and prodded their most productive employees to work longer and smarter.  These productivity gains have allowed the majority of enterprises to maintain their profits during the credit crunch and steep recession.  Solid profit margins should support the recent stock market gains even though valuations are not as attractive as they were earlier in the year.  We still view common stocks as the most attractive asset class versus bonds and cash, but do not expect that volatility will remain as tame as it has for the past nine months.  The market has risen since March without a correction and this pattern will most likely be broken in the coming year.