By mid-November, the stock market, as measured by the S&P 500 price index, had recovered from the post-September 11th sell-off, and was higher than its level just prior to the attacks. The rebound occurred amidst the release of data that almost certainly confirmed that the U.S. economy had entered recession. It remains to be seen whether this stock-market buoyancy will continue, but wise investors will not spend time pondering short term possibilities. A better approach is to focus on longer time periods.

Over the very long term, between January 1926 and October 2001 the S&P 500 provided average annual returns of 10.61%. Nevertheless, in our role as investment advisors we continue to receive inquiries suggesting that many investors expect common stocks to provide annual returns well above 12%.

The extraordinary bull market that began in 1982, after all, provided average total returns of 18.4% per year before the great growth-stock melt down began in April 2000. Moreover, there were several sharp declines during this bull market, but stocks always recovered rapidly.

But memories are short. During the fourteen-year stretch between January 1968 and January 1982, just preceding that bull market, the S&P 500 provided average annual returns of only 5.84%, while 30-day U.S. T-bills averaged 7.19%! If price inflation is taken into consideration, the annual return from stocks falls to -1.57%, while that from T-bills falls to -0.32%. Have we entered a new era in which sharp declines are nothing but short-term buying opportunities, or will the market “revert to the mean” by providing several years of negative and single-digit returns?

Our approach is based on an analysis of historical data. While we cannot predict the timing or the magnitude of the market’s aggregate price level from year to year, our observations suggest that the market’s performance during the last eighteen years is unlikely to be replicated over the next eighteen years. The market has clearly benefited from many positive developments including moderating price inflation, reduced regulation, new technologies, lower marginal tax rates, and freer trade. The extent to which the economy and the stock market will continue to benefit depends a great deal on government policy and how rapidly the initial, positive impact of those trends may diminish.

We will predict that should a period of prolonged single-digit returns ensue, investors will become more cost-conscious. In such an environment investment products and service providers will be squeezed. The plethora of mutual funds (there are currently more mutual funds than there are common stocks) will be consolidated, and “full service” stockbrokers will be forced to reduce their fees.

Our clients and readers are a step ahead. We will continue to research and publish our findings about the most cost-effective means of managing a portfolio, as exemplified in this month’s discussion of exchange-traded funds.

Also in This Issue:

Exchange-Traded Funds
Nobel 2001: The Economics of Imperfect Information
Investment News Briefs
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield