1974: The Long Returns Available at the Moment of Greatest Despair

*By the mid-1970s, serious people were arguing that shares had ceased to be a sensible way to own anything. It was among the most rewarding moments in a century to disagree.*

The bear market of 1973 and 1974 was the most severe experienced by American investors since the 1930s. The broad market fell by roughly half, against a background supplying ample reason for despair: an oil embargo that quadrupled energy prices, inflation with no post-war precedent, a president resigning under threat of impeachment, and an economy contracting while prices rose, a combination the prevailing theories held to be nearly impossible.

The resulting pessimism was not confined to markets, and it was thoroughly reasonable given the evidence. Investors who had held equities for a decade had, by 1974, very little to show for it. The instrument supposed to protect wealth against inflation had conspicuously failed during the worst inflation in living memory, and the argument that shares were a sound long-term holding had been contradicted by a decade of experience.

This mood hardened into a settled conclusion. In 1979, a prominent business magazine published a cover article arguing that equities had died as an investment class, and the argument was not foolish. It observed that inflation had destroyed the real returns from shares, that a new generation had turned away from them, and that the institutional arrangements once supporting them were changing. The reasoning was careful and the evidence real.

It was also, as an assessment of what would follow, almost perfectly wrong. An investor who purchased a broad basket of American shares near the low of 1974 and held it for the following two decades experienced one of the most rewarding periods in the history of the market. The returns available from that entry point were extraordinary, and they were available precisely because everyone else had concluded that they would not be.

The mechanism is worth stating plainly, because it is not mystical. Prices had fallen so far that the earnings of American businesses could be purchased very cheaply. The companies themselves had not been destroyed; they continued to operate, to earn, and eventually to grow. What had collapsed was not the enterprises but the price at which claims on them could be acquired, and the collapse in that price was itself the source of the subsequent return.

Among the few who said so publicly was Warren Buffett, who wrote in late 1974 that the prevailing gloom had produced prices he regarded as extraordinarily attractive, and who observed that a cheerful consensus carries a very high price. His argument was not that he could see the future, but that when everyone is pessimistic one is being offered assets cheaply, and cheapness is the only thing an investor can actually observe.

This is the essential and uncomfortable structure of the episode. The moment at which the largest long-term returns were available was the moment at which the reasons for despair were most abundant and most credible. These two facts are not a coincidence; they are the same fact. Prices are low because the news is bad, and the news being bad is what makes the prices low. An investor waiting for a moment when assets are cheap and the outlook is reassuring is waiting for something that does not occur, because the reassurance is precisely what removes the cheapness.

It follows that the emotional experience of buying near a genuine low is not one of confident opportunism. It is one of considerable discomfort, of acting against a consensus held by intelligent people for defensible reasons, of appearing to ignore evidence that everyone else regards as decisive. Any account of such moments that presents them as obvious in prospect is misleading. They were not obvious. They were terrifying, and that is why the returns were available.

There is a caution that must accompany all of this, and it should be stated firmly rather than buried. The fact that pessimism was mistaken in 1974 does not establish that pessimism is always mistaken. Japan's experience demonstrates that a market can decline severely and remain depressed for decades, and an investor who had bought Japanese shares in the depths of a period of great gloom in the 1990s could have waited an extraordinarily long time. Despair is not a reliable indicator that a bottom has arrived, and treating it as one is simply a different forecast.

What the episode does establish is more modest and more useful. It establishes that the periods that feel worst are not reliably the periods that produce the worst subsequent returns, and that the relationship between the current mood and the future outcome is far weaker than intuition suggests. An investor who sells because conditions are grim is acting on the assumption that grim conditions predict poor returns, and the record does not support that assumption.

It is worth recording what the valuations actually looked like at that point, because the figures explain the subsequent returns more completely than any account of sentiment does. Shares in many established American businesses could be purchased for a small multiple of their annual earnings, in some cases a figure that implied the buyer would recover their entire outlay from profits within a handful of years. Companies traded below the value of the assets on their own balance sheets. These were not obscure enterprises but substantial, profitable businesses that continued to sell their products and pay their dividends throughout the gloom. The market had not concluded that these businesses would cease to exist; it had simply stopped being willing to pay very much for them. An investor at that moment did not need to forecast a recovery in sentiment in order to do well. They needed only to purchase profitable enterprises cheaply and to wait, which is the least glamorous proposition in investing and, on this occasion, the most rewarding.

At VESTFY™ the 1974 low is presented as the strongest available demonstration that an investor's feelings are not information. The most credible, best-argued, most widely shared assessment of the market's prospects was published near the beginning of one of the great advances in its history, and it was wrong not because its authors were foolish but because the future is not deducible from the present mood, however carefully that mood is reasoned.