The Importance of a Long-term Perspective

In order to gain some perspective on the current state of U.S. equities, it is helpful to review how the market performed over long-term periods in the past.

Historically, trailing 10-year returns for U.S. stocks have rotated from low-to-high and high-to-low. The December 2008 period represented a new low. In each of the prior periods when 10-year returns approached or fell below zero, subsequent returns improved, eventually exceeding 15% on an average annual total return basis.

These long-term results reinforce the cyclicality of the U.S. equity market. As short-term events pulled down share prices, opportunities arose that set the stage for market's next up phase.

Why Small-Caps

Although many investors believe that small-caps tend to shine when the market is roaring, historically, the opposite has been true. For small-cap investors, it has been the periods that fell below peak general market returns that have offered the best opportunities on a relative basis.
While large-caps generally outperformed small-caps during periods of high 10-year returns, small-caps had more periods of outperformance during normal-and lower-return 10-year periods.

The current period is no exception. As of June 30, 2009, the 10-year average annual total return for the Russell 2000 was +2.4%, while the S&P 500 suffered an annualized loss of 2.2%.

The Impact of Short-Term Events

While keeping one's expectations reasonable and having a long-term view are important, it's striking that the most dramatic market movements generally occur over relatively short time spans. For example, while the 10-year returns for the market as of June 30, 2009 were very poor, it was two distinct shorter-term experiences that capsized returns: the post-bubble correction that lasted 2½ years (March 2000 through October 2002) and the current market turmoil that has so far lasted approximately 1½ years (whether measured from the small-cap peak in July 2007 or the large-cap peak in October 2007).

For the S&P 500, these two declines represented a total loss of 76.5%, which occurred in just under four years. For the remaining six years, the index's total return was an impressive 239.1%. For the small-cap Russell 2000, the results were similar, though with even stronger positive results. The small-cap index's return during the two major declines within the past 10 years resulted in a loss of 78.4% in a little more than four years. In the nearly six years of generally rising markets, the index gained 413.1%. The impact of these shorter-term declines was therefore highly significant.

Why Now?

Their impact can be further evaluated by examining historical five-year results for small-cap stocks. For the CRSP 6-10, five-year returns have ranged from a low of -29.8% to a high of 57.0%. Perhaps not surprisingly, the period of the highest returns followed on the heels of the period with the lowest returns.

In the post-World War II period, there have been 700 monthly trailing five-year periods for the CRSP 6-10 index. During this period, the index's returns were negative only 5% of the time and between zero and 10% only 26% of the time; in the remaining 69% of the periods, the index posted double-digit returns.

One of the most significant aspects of this record is the experience of the index following those periods when its return was below zero. Each time that the CRSP 6-10's five-year average annual total return was negative, the subsequent return was above 10%, and was above 20% nearly two-thirds of the time.

So while the market's current gyrations have increased investors' anxiety and perhaps about small-caps in particular, the seeds of the market's next up phase are likely being sown within these same dismal conditions. While some continued volatility is likely, we believe the market's next movement should be rewarding for many small-cap investors in both the short- and longer-term.

* Mr. Siegel combined the market data collected by William Schwert (1802-1870), the Cowles Indexes (1871-1925) and Standard & Poor's (1926-Current). The data for the 1802-1870 period consists primarily of bank stocks traded in Boston, New York and Philadelphia, with additional companies added over time. The Cowles Index Data (1871-1925) consists of all stocks listed on the New York Stock Exchange. The data supplied by Standard & Poors (1926-2008) consists of the S&P Composite Index prior to 1957, and subsequently, the S&P 500 Index. Compound Annual Growth Rates ("CAGR") include dividends reinvested.