Recovering from a market rout doesn’t have to take decades
The U.S. stock market dropped 57 percent from its peak in late 2007 through March 9 of this year, making this the second worst bear market since the Great Depression.
Investors, quite naturally, want to know how long a recovery will take. We are constantly reminded of an ominous precedent: the Dow Jones Industrial Average hit a high in 1929, plunged, and then took 25 years to recover. Will today’s market behave in similar fashion?
The premise of a long recovery, however, may be a straw man: it really only took the broad stock market about 4½ years to recover from the 1929 crash if dividends and deflation are taken into account, says Mark Hulbert of The Hulbert Financial Digest.
Real vs. Nominal
Investors have a bad habit of looking at nominal numbers over time without adjusting for inflation. But that’s just wrong: $1 received in 1975 was worth a lot more than $1 received today due to inflation over the last 34 years.
In the Great Depression the country suffered from deflation, so that $1 received in 1936 was worth 18 percent more than $1 received in 1929. So although the stock market had not hit its former high in nominal terms, even at a lower nominal level it was worth more than in 1929 due to deflation.
Another consideration is dividends: market averages like the Dow merely look at current and historical stock prices and do 
not take into account all the dividends paid over time, which have a real effect on an investor’s wealth.
By the time the Dow hit its Great Depression low in mid-1932; its dividend yield was 14 percent. An investor who reinvested dividends over this period recovered more quickly than did the Dow average.
The IBM effect
The big question is whether the Dow is a good representative for the U.S. stock market, back in 1929 or even today. The index consists of just 30 large stocks. Its makeup changes periodically based on the judgment of a committee at Dow Jones & Co., which publishes The Wall Street Journal.
Up and comer IBM was a member of the Dow average until it was inexplicably deleted by the Dow Jones committee in 1939. It was restored to the index 40 years later.
It has been estimated that if IBM had stayed in the index continuously over that period, the index would have been twice as high in 1979.
IBM was one of the best performers of large stocks in the 1940s, and its inclusion most likely would have sent the Dow’s nominal number well above the levels it actually reached.
1938 recovery
The market hit its Depression low in mid-1932, three years after the 1929 crash. Ibbotson Associates has estimated that in real terms, the market probably had fully recovered just four years and five months after that low.
Other bear markets have shown similar trends: the average recovery since 1900 is just two years. The big exception was the recovery from the 1973-74 bear market.
The low in that market was December 1974 and U.S. stocks did not fully recover for eight years, when, in 1982, the Dow rose higher than the previous high in 1972.
Investors who bet against the market now could be right for several years yet, but they will eventually be disappointed if the market follows its historic pattern.