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The current
economic downturn that has been erasing jobs as fast as it erases
points off the Dow was created in large part by an excess of
leverage. Individuals, companies, and governments spent far beyond
their means, facilitated by easy borrowing from the Chinese (in the case
of government) or by pulling money from the ever expanding equity in
their homes (in the case of individuals). We're now in what is
likely to be an extended period of "deleveraging" during which
individuals, businesses, and governement will need to rebuild balance
sheets. For the moment, government is doing just the opposite in an
attempt to make up for the fall in demand by the other two groups, but even
governments will eventually be required to pull in their horns and deal
with ballooning debt. This could very well lead to weak growth even after
the economy bottoms out, a scenario some call "extended
malaise."
Guy Cumbie, a
good friend and colleague, shared his exploration of this scenario with us
over the weekend. He harkened back to the last time we experienced a
period of extended malaise and examined what the implications had been for
stock market investments.
The Dow Jones
Industrial Average was at 1,000 in 1965 and was at 1,000 again in
1981. It goes without saying that the economic challenges during that
period were the most extreme that had been seen since the 1930s, and
included a major war, massive government deficits, two oil shocks,
inflation, and flat economic growth (the last two of which combined to
form the dreaded "stagflation"). Whether or not the current
period will prove to be as challenging is yet to be seen. With dividends
included, however, the average annual rate of return to the Dow over that
17 years was 5.22%. Over the same period, the S&P 500 had an annual
average total return of 6.82%. The Investment Company of America Fund, a
conservative, open-end mutual fund that was investing in a somewhat wider
universe than either of the indexes had an annual average rate of return of
9.47%. A portfolio that included small company,
value, and foreign stocks did better still. Economic challenges don’t mean
that stocks don’t provide positive returns. The economic evidence
shows that companies adapt to economic conditions, whether inflation,
deflation, oil embargoes, or other shocks, and move on.
In short,
even if those predicting extended malaise are correct -- and we're not by
any means saying they are! -- diversified portfolios can still provide
attractive performance to patient investors.
Dave
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