"Man looks in the abyss, there's nothing staring back at him. At that moment, man finds his character. And that is what keeps him out of the abyss."

--Quote from a character in the 1987 movie, "Wall Street"

I. Where Are We?

• Most investors (us included) will be all too glad to see 2008 come to a close as the ongoing correction in housing led to severe dislocations in the credit markets, huge write-downs and failures in the financial sector, and subsequent deleveraging across the capital markets, leaving almost no asset class unscathed.
• From its late 2007 peak to its recent low in November, the S&P 500 declined almost 52%, which qualifies as the sharpest bear market decline since the 1930s. To put the sheer magnitude and velocity of this drop into perspective, in just 13 months stocks slightly exceeded the damage done in the two most recent mega bear markets: the ‘73/'74 oil shock/runaway inflation induced bear market lost 48% over 21 months, and the bursting of the Technology bubble earlier this decade saw stocks lose 49% over 31 months.
• As we head into 2009, the economic backdrop remains weak, the jobs picture has been deteriorating, and the S&P 500 will likely see a decline in year-over-year earnings. Given these factors, it would be easy to assume there is little basis for stocks to rise, yet history suggests there is reason for some cautious optimism.

"Indeed, the evidence is compelling that when decade-long real stock returns are inordinately high by historical standards, returns in subsequent decades are likely to tumble; when past returns are exceptionally low, future returns are apt to rise. What it's all about, it seems, is reversion to the mean."

--John Bogle, founder and retired CEO of The Vanguard Group

• Through the end of November, the total 10-year rate of return for the S&P 500 was -0.93, which is worse than any rolling period since the 1930s/1940s. After such horrific returns, some investors are simply extrapolating the recent performance trends into the future, yet we view such linear thinking as a mistake and comparable to expecting the exceptional gains of the 1990s to continue in perpetuity. Moreover, while the past is only a guide, and in many ways the market is making its own "new" history, periods of extended underperformance have generally preceded improved longer-term performance (and vice versa as shown in Figure 1).

Figure 1 Poor 10-Year Stock Returns Have Typically Led to Better Forward Returns

Chart through end of November 2008

Source: Thechartstore.com; SunTrust Robinson Humphrey

• To this point, The Leuthold Group recently reviewed the S&P 500's record following the worst 10-year rolling periods of performance dating back to 1926. As illustrated in Figure 2, their work found subsequent returns after such poor performances were positive, with the S&P 500 averaging a total 10-year return of 183%, or an annual compound return of 10.67%.

Figure 2: Subsequent 10-year performance after worst 10-year performance (S&P 500

Source: The Leuthold Group, LLC

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