The Taylor Frigon Advisor: Return of the 1970s, part 2

During historic times such as this one, it is useful to go back in history to glean potential lessons.

Investors observing the massive increase in government spending are justifiably concerned about two negative side effects: a reduction in economic growth as government spending reapportions funds from the private sector to the public sector, and an increase in inflation. For a discussion of why these are justifiable concerns, see for example the video embedded in this previous post.

The period of history most closely associated with slow growth and rising inflation is of course the 1970s. While we are not suggesting that we are heading into an extended period of years which will exactly parallel the seventies, continuing government expansion into the private sector could well lead to an environment in which growth will be more difficult for companies, and therefore more difficult for investors to find.

We have previously observed in our first post entitled "Return of the 1970s?" that although the seventies were a difficult decade for the economy and for investors in general, there were some innovative businesses, particularly smaller companies, which outperformed tremendously.

We contend that exceptional, innovative companies will always be sought-after investments, but that in difficult economic environments where growth is hard to find, they become even more significant.

Take a look at the annual total return data listed in the chart above, published by Ibbotson Associates in their annual SBBI (Stocks, Bonds, Bills and Inflation) Yearbook. The total returns for large-company stocks (represented in this Ibbotson study by the S&P 500 Stock Composite Index) and for small-company stocks (represented in this Ibbotson study by the fifth capitalization quintile of stocks on the NYSE for years prior to 1981, and by the DFA Small Company Fund thereafter) are shown for the years 1973 through 1984.

The data for those years offer several lessons for the investor. First, it is clear that after the significant bear market of 1973-1974, stocks rebounded sharply in 1975. This alone is important for investors to appreciate, languishing near the lows of a current bear market that has been even more severe than the 73-74 bear market.

It is quite possible that the markets will snap upward with startling velocity when the current banking crisis is resolved. We believe that mark-to-market accounting continues to play a major role in holding the financial system hostage, as we have discussed several times previously (for instance here, here, and here). Repeal or even temporary suspension of the rule may well serve to ignite such a rally.

As impressive as the 1975 and 1976 rebound was for the market, the 52.8% return in 1975 and 57.4% return in 1976 for small-company stocks dwarfed the 37.2% and 23.8% returns for large-company stocks in those same years. In fact, from 1973 through 1983, small-company stocks decisively outperformed large-company stocks every single year, including 1977 and 1981 in which the S&P had negative years and small-company stocks returned 25.4% and 13.9%, respectively.

In 1984, large-company stocks outperformed, with a positive return of 6.3% compared to the negative 6.7% return of small-company stocks. This ushered in a period in which large-company stocks prospered for almost two decades, fueled by a benign environment of lower government intrusion, low inflation, and plenty of the liquidity that the giant enterprise corporations typically need in order to continue growing.

We believe that the market environment of 1984 through 1999 was positive for the kinds of large companies that make up popular indexes such as the S&P 500, and that this period led to the rise of the belief that investors should "just own the index" and they will do well. We have outlined our disagreement with some of the assumptions at the core of "index investing" in previous blog posts, such as this one.

However, during more economically challenging periods, where growth is harder to come by, the same larger companies can generally tread water, and selection of well-run companies involved in some kind of business paradigm shift can become much more important. (For those who look at the chart above and feel that the returns of the large-cap companies during the 1970s don't look too bad all by themselves, remember that during this same period of time, annual inflation was in the high single digits and even the double digits, severely impacting the investor's real return).

Those who continue to believe that investors should "just index" and that the S&P 500 should be the core of most investment portfolios may want to revisit the history of the so-called "Nifty Fifty" stocks that became popular in the 1960s. These large-cap stocks were billed as "one-decision" stocks that an investor could buy once and never sell.

While there is some variation between lists published of the "Nifty Fifty," as explained in this study, it is generally agreed that the Nifty Fifty companies and their stocks prospered in the liquidity-rich 1960s and early 70s, only to be decimated in the 1973-1974 bear market and languish thereafter. The strategy is now history.

We would suggest that such "passive" investing strategies as the Nifty Fifty and the "just index" idea may arise in certain periods that allow broad swaths of companies to grow, but that in difficult environments, a much higher percentage of companies may become bogged down or mired in place, and that serious growth must be found outside of the broad herd and among the narrower population of nimbler, more innovative companies. History suggests that these nimbler innovators will more often be found among smaller companies.

We believe that we may be entering just such a period of investing. For some insights into the investment process that we have always used to find these kinds of businesses, you can use the search window in the upper left corner of the screen to find previous posts on "growth stock investing," such as this one.

For later posts on this same topic, see also: