2009 ends a decade (1999-2009) where for the first time in history, the S&P 500 index ended with a loss. It is the only time the Dow Jones ended a 10-year period with a loss since the great depression (1930-1940).
So, does this mean that Warren Buffett’s buy and hold theory for compounding wealth is dead? Does this mean that the theory that buying the index for almost guaranteed returns in the long term does not work? What does this mean for the next decade?
What Happened in this Lost Decade? (1999-2009)
So, what caused stocks to ‘suck’ over this period? The answer is simple: valuation!
At the starting point of this decade (i.e. 1999), stocks were at its most overvalued in history! In 1999, the average price-to-earnings ratio (PE ratio) of the S&P 500 index was a mind boggling 43! (when the historical mean is 15). Take a look at the PE ratio of the top 10 stocks making up the S&P 500 in 1999.
Microsoft, PE Ratio: 72 times earnings.
General Electric, PE Ratio: 47 times earnings
Wal-Mart, PE Ratio: 57 times earnings
IBM, PE Ratio 29 times earnings.
If you had bought stocks in 1999, you would have paid an average of 43 time earnings! This means that companies will have to growth profits at 43% every year for ten years for your stocks to have a chance to make money for you. That’s ridiculous and impossible. . That was an enormous headwind on returns over the past decade. And that is why stocks have gone nowhere over the past 10 years, because your starting point was so high in terms of valuations that almost no degree of earnings growth could have overcome that enormously high level of expectations implied by 43 times earnings. It’s kind of like peddling uphill on a bicycle against this enormous weight of a PE ratio.
How about today in 2010. What are stock valuations today? Let’s take a look at the top 10 stocks in the S&P now.
Microsoft, PE Ratio: 19.77
General Electric, PE Ratio 13.51
Wal-Mart, PE Ratio: 15.45
IBM, PE Ratio 13.48
If you bought stocks today, your average PE ratio would be about 15 times earnings. This means that the market is at fair value today and as a result, there is a high chance (in my opinion) that the next decade would give the investor of today much higher returns, since you are buying the market at a fairly reasonable price. Of course, if you had started buying stocks in mid-2009, when I shared the ideas in my book ‘Profit from the Panic’, you would have paid a PE ratio of 6-8, which was a time when the market was unusually undervalued. That would boost your returns even more.
Is Buy and Hold Theory Dead?
Many people ask me if the theory of buy and hold over the long term is a dead theory that doesn’t work anymore in today volatile market. Personally, buy and hold strategy is still the very best way to invest and compound your wealth. Personally, I have found that I have made the most money in investments where I was in it for the long term versus small money I make trading in and out.
HOWEVER…. Buy and hold long term only works IF you buy the RIGHT COMPANIES at the RIGHT PRICE. This means following the 9 Step Value Investing Criteria taught at Wealth Academy and buying only when stock prices are safely below intrinsic value. If you are buying the Index, buy when PE ratios are 15 or below. If you follow these rules, you will always end up making money in the stock market. Break these rules and you will lose money. Buffett follows these rules and that is why he MADE LOTS OF MONEY in the last decade while the market index lost money
How Did Buffett Do In this Decade?
Lets’ see how well Buffett did versus the S&P 500 with his contrarian, buy and hold strategy. Shares of Warren Buffett’s Berkshire Hathaway far outperformed the benchmark S&P 500 stock index over the decade, Buffett achieved a gain of 76.8% while the S&P lost 24.1% over the same ten year period.
Source of Charts: www.CNBC.com
How did he achieve this? Simple. He stayed away from the stock market in 1999-2000 when PE ratios were 40+, especially technology stocks. When everyone else was greedy and buying, he was fearfully staying away. Can I also proudly and shamelessly brag that I did the same thing? That is where education and modeling great minds pay off.
At the same time, Buffett bought stocks in 2003 (after the Dot com crash) and 2008 (in midst of the financial crisis) when fear drove PE ratios to below 10. He was being greedy when others were fearful. So, going against the crowd and sticking to sound investment rules (laid out in Wealth Academy and my books) will give you that winning edge. This is why I shared that it was a great time to buy stocks in my book ‘Profit from the Panic’.