Preview

This year's stock market decline has received a lot of media attention. But what most people don't realize is that the stock market has been silently losing value for almost a full decade.

Measured in dollars, the S&P 500 is down almost 15% since its 2000 highs. Adjusting for inflation or measuring with almost any other yardstick, the index is down substantially more.

This would be great if stocks were finally cheap again, but I don't see any evidence of that yet. When all is said and done, I expect the stock market to go quite a bit lower from its current level, not only in dollars but even more in terms of purchasing power.

The Silent Market Crash

Perhaps this title would have been more appropriate this time last year. But the decline measured in dollars greatly underestimates the true loss in purchasing power of stock market investors. Below is a chart of the S&P 500 priced in U.S. dollars:

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The S&P 500 is down 15% from its peak in 2000. That's pretty lousy for an 8 year investment. I suppose if you had invested at the March 2003 lows (did anybody actually invest at this bottom?), you would be up 50%.

The problem is that inflation averaged 2.5% since 2000, and the adjusted loss has been 32% (you'd still be up 28% from the 2003 lows):

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But inflation doesn't even capture the whole story. The thing that has always bugged me about inflation is that gains in productivity and the benefits of globalization should drive prices down if the currency were truly stable. So the fact that prices are not falling is already bad enough. Still, I am expecting more consumer price inflation in the next few years as currency depreciation and higher commodities prices work their way through the system.

Another important measuring of value compares the dollar to a basket of other currencies. Since 2000, the dollar index has lost nearly half its exchange rate:

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After adjusting for the currency differential, the S&P 500 is down 45% since 2000 and only up 5% since 2003. The stock market may have had a bounce in dollar terms, but the loss in the value of the dollar completely offsets any gains:

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Things are even worse when you price the stock market in oil or gold (items which are less sensitive to productivity gains than many items in the CPI such as apparel and computers):

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Click on the image above for a sharper version

Perhaps the S&P 500 priced in oil isn't completely fair. After all, the price of oil has increased more than 5 times since 2000:

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But oil is priced in dollars, which are losing their value. If you price oil in gold (a more comparable measuring stick), the gains have been more modest (although the chart currently suggests a pullback in oil relative to gold):

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Finally, with the price of eggs going up 75% since 2001, one share of the S&P 500 used to buy as much as 1200 eggs and now it buys only 600 eggs. That's a 50% decline in the number of eggs your stock portfolio can buy! I mean seriously, how are we supposed to afford breakfast anymore??

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Hat tip to Peter Schiff

At the end of the day, individuals invest in the stock market so that they can consume more in the future. Investing in the U.S. stock market at any point since 2000 has not produced this outcome. Is this really the bull market in stocks that Wall Street has been telling us about for the last 5 years?

Where to next?

The real question is whether the most recent price declines have created enough value to start buying again. In this regard, I largely agree with John Hussman's latest weekly column:

"Unfortunately, for the S&P 500 to be reliably priced to deliver long-term returns of 9% or more without relying on multiple expansion, the index would have to move below 900. That said, there is no reason that a full revaluation of stocks has to occur in this particular cycle. Secular bear market periods, which I believe the market began in 2000, generally involve a series of cyclical bull-bear cycles which gradually take valuations lower at each successive cyclical trough (even if prices don't fall below prior troughs).

In any event, the S&P 500 is presently not a compelling value taking the index as a whole, though there are individual stocks that we hold in the Fund that do appear to be undervalued."

- Projected Long-Term Market Returns are Still Tame

Future U.S. stock market returns are likely to be low relative to the risks that remain. My personal view is that the market will continue to go lower from its current level, even in dollar terms.

As for the dollar, it's hard to say with certainty whether it will continue its decline. That chart of the dollar index looks pretty bad already. But given that the dollar rally in the late 1990s coincided with an overly optimistic financial market (Mr. Internet Bubble) and an overheated U.S. economy, I think the dollar can still fall substantially from here.

Anything is possible, of course, but I'm not holding my breath for another dollar rally. After all, we have still not solved the structural trade and budget deficits that began in the 1980s.

Conclusion

Investment returns matter only to the extent that you can buy more "stuff" in the future. The U.S. stock market has been slowly losing real purchasing power for almost a decade, with no signs yet of a trend reversal.

It's true that the prices of hard assets like oil, gold, and omelettes have been increasing rapidly, but this is a direct consequence of decades of underinvestment in these asset classes. If you're not thinking about investing in terms of purchasing power, then you're playing the wrong game.

I hate to sound so pessimistic (wait, do I really?), but there is a silver lining. It is precisely during these times that you can gain relative value by going against the conventional wisdom of a stock market index portfolio.