3 Lessons from Stocks’ Round Trip

The Comeback

In autumn 2022, the financial news was miserable. By Oct. 14 of last year, $10,000 invested in Morningstar US Market Index when the year began would have dwindled to $7,506. That represented the ninth-largest loss for United States stocks over the past 75 years. Although not a generational event, the decline was officially a bear market, at the level that deters many would-be equity investors.

Fourteen months later, the damage has seemingly been erased. Stocks have finished a round trip, as that hypothetical $10,000 investment finished last week worth $10,068.

No harm, no foul? Not quite.

Lesson 1: Real Returns Matter

In one sense, people realize that there is more to returns than meets the initial eye. With everyday life, they readily appreciate the difference between real and nominal gains—that is, between results adjusted for changes in inflation and those that are not. Over the past two years, U.S. wages have grown by 8.5%. Hey, great! However, inflation has increased by 9.6%. What counts is purchasing power—and that has gone backward rather than forward. Voters are therefore unhappy. (That said, wage growth has exceeded inflation in the past 12 months.)

However, it’s easy to forget that intuition when surrounded by investment performances that are computed in nominal terms. Mutual fund total returns are mandated by the SEC to be shown nominally, and all third-party sources—including Morningstar—follow suit. Similarly, stock research either operates in that fashion, or even more crudely, by measuring price changes while omitting the effect of dividends. (For example, the Dow Jones Industrial Average.)

While there are valid reasons for those decisions, it nonetheless can be valuable to insert some, ahem, reality into the presentation. The following chart accomplishes just that, by depicting the real growth of $10,000 for Morningstar’s index since Jan. 2, 2022, along with the previously cited nominal result.

Despite their apparently full recovery, equities have considerably further to go.

Lesson 2: The Value of Downside Protection

The “Magnificent Seven” dominate today’s stock market headlines. This month alone, Morningstar has published three stories about those growth-stock darlings: Amazon.com AMZN, Apple AAPL, Alphabet GOOGL, Meta META, Microsoft MSFT, Nvidia NVDA, and Tesla TSLA. Those articles, along with dozens circulating elsewhere, chronicle how those listings have propelled the stock market indexes, while most stocks from everyday companies have languished.

Presumably, then, large growth has been the top-returning U.S. equity style over the past two years. After all, if the Magnificent Seven’s 2023 performance has been powerful enough to carry the entire U.S. stock market on its back, it must have worked even greater wonders for the large-growth subgroup, to which each member but Apple belongs. (Morningstar categorizes Apple as a large-core stock.) Sure enough, the large-growth stock index has gained 47% for the year to date.

However, while large-growth stocks have led this year’s stock market, and by a wide margin, they have not in fact been the best two-year performers. The contest has not even been close. The next chart shows the growth of $10,000 since January 2022 for the four corners of Morningstar’s investment-style box. (This time I did so solely in nominal terms because inflation affects each index equally.) The Magnificent Seven’s achievements notwithstanding, large-growth stocks placed a distant third, ahead only of their small-growth cousins.

The culprit was the depth of their decline. In mid-October 2022, when U.S. equities overall were down 25%, large-growth stocks had lost 42%. Those extra 17 percentage points made a very large difference. From that date, the stock market required a 33% gain to reach its nominal breakeven point. In contrast, large-growth stocks needed a 75% bump. Consequently, despite their spectacular 2023 performance, they still have much further to go.

Lesson 3: Low-Yielding Bonds Can Be Dangerous!

To their credit, bonds did hold up better than equities during the worst of the downturn. I don’t mean long-term bonds—they were obliterated. But the short- to intermediate-term securities typically owned by retail investors, either directly or through funds, lost less money. At its bottom, a $10,000 investment made in January 2022 in the Morningstar Core Bond Index dropped to $8,329, which placed it more than $800 above the low point for stocks.

The problem was that bonds lacked the firepower to recoup their markdowns. Had bonds offered generous yields when their slide began, they would have achieved even higher payouts that would have enabled them to recover their lost ground. A 10% yield does wonders for a security’s total return. But at 4%, today’s bond yields remain modest. To recapture what was forgone, bonds must rely heavily on capital appreciation—which, for the most part, has yet to arrive.

Consequently, bonds remain well below water. Since January 2022, the nominal value of a $10,000 investment in the bond index would have slipped to $9,119. Its real worth would be a mere $8,244.

If bond yields stay at their current level, and inflation averages 2.5%, bonds will earn an annual real return of 1.5%. At that pace, it would take the bond index more than a decade (!) to reach where it started, in inflation-adjusted terms. In summary: When yields are low, bonds are by no means a safe asset. They protect well against recessions, but if shocked by unexpectedly high inflation—as recently occurred—they can suffer setbacks that take a long, long time to overcome.