By: GZ on Lunedì 12 Agosto 2002 16:58
-------------------- Historical views of the market need adjustment for reality
By BRYAN TAYLOR -------------------
The plunge in stock markets in July pushed the United States stock market into its worst showing in years. But is this bear market worse than other famous ones? It depends on how you look at them. Most historic analyses of bull and bear markets look at the changes in the prices of a stock index such as the Dow Jones Industrial Average or the Standard & Poor's Index of 500 stocks, but they leave out three important factors that make quite a difference: dividends, inflation and taxes.
The S&P 500 is the broadest market index with the longest stock-market history. We'll look at it first, defining a bull market as an increase of 40% from the lowest close to the highest close on the index, and a bear market as a decline of 15% from highest close to lowest close on the index.
Here's the first important adjustment: Instead of using the S&P Composite Price Index, we should use the Total Return Index. Since most individual investors have their money in mutual funds that reinvest their dividends, using a price index to determine the movement of markets does not reflect the results that investors receive.
Dividend yields are currently at historically low levels, so using a total return analysis increases the overall return to investors in the past more than in the present. The 1920s bull market topped out on Sept. 7, 1929. If some late-arriving bull had invested money in the stock market on that day, how long would he have had to wait to get his money back? Using the price index, the answer would be September 1954, but on a total-return basis, this unluckiest of investors would have broken even in April 1945 -- nine years earlier. Similarly, the S&P Price Index in April 1942 was still below its level in June 1901, but on a total-return basis someone who had invested in the market in June 1901 would have gotten a seven-fold return between 1901 and 1942 because of the role of reinvested dividends.
Accounting for dividends reduces the size of the declines during bear markets and increases the returns to investors during bull markets. On a total-return basis, the bull market of the 1920s registered a 657% increase as opposed to a 409% increase on a price basis. Total returns also change the timing of the bull market tops and the bear market bottoms. The reason for this is in both periods, investors receive dividends that increase their returns. Using the current bear market as an example, the S&P Composite Price Index had its highest close on March 24, 2000, at 1527.46, but the S&P 500 Total Return Index had its highest close on Sept. 1, 2000, at 2108.76, a difference of five months.
The overall impact of dividends is to shorten the length of bear markets and increase the length and size of bull markets. This difference can be seen in the bear market that followed World War II. The bear market began on May 29, 1946, hit a bottom in May 1947, then bounced up and down for two years, hitting a slightly lower low on May 13, 1949, before beginning a dramatic seven-year bull market. However, on a total-return basis, the market bottomed out on May 17, 1947, two years before the price index.
Investors also have to consider inflation. Between 1966 and 1982, when the Dow Jones Industrial Average struggled to move above 1000, consumer prices tripled. Adjusted for inflation, the DJIA declined by two thirds. Including inflation improves the returns from the 1930s when prices were falling, reduces the returns after World War II when inflation picked up, and has the strongest impact on returns from the 1970s when inflation was at its worst. We can adjust for inflation by dividing the index values by the Consumer Price Index.
Since prices fell during the 1930s, the real Total Return Index had returned to the levels of September 1929 by the market top in March 1937. Although the deflation of the 1930s reduces the decline in the 1929-32 bear market to 79.3%, we also find that as late as 1947, investors were still below the peaks of 1929 on a real total-return basis.
On a price basis, the 1973-1974 decline (-48%) was worse than the bear market of 2000-2002 (-47.8%), using July 23, 2002, as the current bottom, but not as bad as the 1937-38 bear (-54.5%). If you include dividends and calculate total returns, the 2000-2002 bear market (-46.6%) already is worse than the 1973-1974 bear (-45.1%), but not as bad as the 1937-38 bear (-51.2%). But if you adjust for inflation, the 1973-1974 bear market (-54.2%) not only becomes worse than the 2000-2002 bear (-48.1%), but worse than the 1937-38 bear (-51.2%), as well. Depending upon your definition, you can choose any one of the three as the worst bear market.
No analysis of investor returns would be complete without including taxes. The problem is that taxes vary by income bracket and by residence since some states have income taxes and some do not. Let's base our numbers on an individual who is making $200,000 in 2002. If he had earned an equivalent amount of money in the past, by how much would have federal taxes reduced his returns?
Until 1939, taxes were relatively low. Someone making $20,000 a year in the 1930s, equivalent to $200,000 today, would have seen a marginal tax rate between a low of 5% in 1929-1932 and 19% in 1937-1938. Capital gains were taxed at the same rate as income taxes, but the maximum rate was 12.5%. Taxes were raised dramatically during and after World War II, with a top marginal tax rate of 93% at one point in the 1950s. Our investor would have faced a marginal tax rate of anywhere between 47% and 57% with 50% the average. Beginning in 1938, long-term capital gains received a 50% exclusion, and from 1942 until 1967, the capital gains tax was capped at 25%.
It is little wonder that after World War II, capital gains became an increasingly important part of investor returns. Since 1950, on average, about one-third of investor returns have come from dividends, and two-thirds have come from capital gains, so most investors would have paid about 30%-33% of their stock-market returns in taxes between 1942 and 1986.
In 1986, the tax system was reformed and rates were lowered. The top tax rate was set at 28% on both capital gains and dividend income. In 1993, the rate on someone earning $200,000 was raised to 36%, and the long-term capital-gains rate was later lowered to 20%. The net effect since 1987 has been to make investors pay about 28% of their stock-market returns in taxes. Investors facing state income taxes have to pay even more.
Adjusted for dividends, inflation and taxes, the bull market of the 1920s looks even stronger than it ever did before. Not only were dividends higher and inflation lower than after World War II, but lower taxes also increased net returns considerably. Investors of the 1920s got to keep almost 90% of their gains after taxes. Since World War II, lower dividends, higher inflation and higher taxes have all reduced the net after-tax real total return to investors.
In the current bear market environment, perspective is more important than ever. The history of bull and bear markets reminds us that bear markets do end, that bull markets are stronger and last longer than bear markets, and that in the long run, the overall rise in stocks far offsets the declines.
Bryan Taylor is president of Global Financial Data. He is an economist who does research on long-term behavior of markets.