It looks like the period 2000 to 2005 is the third instance where rolling 5 year returns of a broad stock market index might be negative. What is your outlook for the next 5 to 10 years? Are we in for a sub-par period to offset the above average trend of 1990 to 2000?
The question begs two others. First, is the market mean reverting over a single or multiple business cycles? Second, is there something different in this business cycle (or the next one) that would lead one to believe that the stock market will not live up to its long term average performance? I'm happy to share my opinions.
A mean reverting market is one that returns to the mean (the statistical average) from periods of over or under performance. In a previous post, I noted that performance in the stock market followed performance in the economy. The economy is subject to cycles. As such it has recessions followed by periods of economic growth. This makes the stock market follow cycles also. It goes down as a result of company's struggles during a recession and goes up during periods of economic growth as companies prosper. This is the main driver of the stock market. It looks like mean reversion, but it isn't. There is some evidence that there is some mean reversion in the stock market. It is related to the behavior of people. For any piece of economic or company news, people tend to over react. The market goes beyond where it logically should. Eventually, enough analysts note that the market is mis-priced and it returns to its proper price. This type of mean reversion is a short term phenomenon and does not extend across business cycles.
So, in answer to the first question, there is little reason to believe that the market will under perform for an extended period just because it out performed for a long period. There were economic and political reasons for both the out performance of the '90s and the under performance so far in this decade.
What about economic factors? So far, this business cycle has performed in line with the average of previous cycles. We are about mid-cycle or late mid-cycle. Company profits have been very good. Productivity has been excellent. Balance sheets have been significantly repaired.
So what does the rest of the cycle look like? Typically, at this stage of a cycle productivity slows dramatically. This is happening. Companies begin to run up against capacity constraints. This is happening. Employment begins to get tight, and the profits that flow to the bottom line from productivity improvements start to flow to labor. There is great debate as to whether this is or will happen. Why?
The short answer is India and China. They may be putting a lid on labor costs by vastly expanding the pool of available labor. The question is how much of our labor is transferable to these economies. No one knows for sure. My personal belief is that we are near the current limits and that labor will get tighter. Profits will moderate and stock market gains will be in the 8% to 10% range for the next year.
I don't see a recession for the next couple of years and I expect the market will be at the low end of its average. These are just my best guess at this point in time given what I know. I think over the next decade you can expect about average returns unless we have more exogenous events like 9/11.
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