On page 22/23 of his work One Up On Wall Street, Peter Lynch explained why the stock market declines of 1990 bothered him a lot more than those of 1987: “While the 1987 decline scared a lot of people (a 35 percent drop in two days can do that), to me the 1990 episode was scarier. Why? In 1987 the economy was perking along, and our banks were solvent, so the fundamentals were positive. In 1990 the country was falling into recession, our biggest banks were on the ropes, and we were preparing for war with Iraq.”
When you see the prices of your non-cyclical stocks decline by more than 20%, the subsequent question that you should immediately ask is: Are the dividends and overall profits falling substantially, too?
Outside of the financial sector, the stock market crash of 2008-2009 was not accompanied by a joint decline in the profits of America’s heavyweight corporations. When you look at the cereal makers, Kellogg grew its profits from $2.99 to $3.16, and raised its dividend from $1.30 to $1.43. For General Mills, profits grew from $1.76 to $1.99, and the dividend rose from $0.79 to $0.86.
In retail, Wal-Mart continued to do what it has done my entire life, delivering annual growth by just about every metric imaginable—earnings, cash flow, dividends, sales, etc. Profits during the recession grew from $3.42 in 2008 to $3.66 in 2009, and the dividend increased from $0.95 to $1.09.
Among the no-nonsense blue chips, the results were quite similar. Pepsi grew its profits from $3.21 to $3.77, and raised its dividend from $1.60 to $1.75. Johnson & Johnson grew its profits from $4.57 to $4.63, and the dividend increased from $1.80 to $1.93. At Procter & Gamble, profits remained steady, going from $3.64 to $3.58, and the dividend went up from $1.45 to $1.64.
One of the things that made the recent financial crisis easy to handle (outside of financial sector investments) is that the profits at the non-cyclical blue chips held up well despite lower stock prices. I get what Lynch is talking about when he says that declines in earnings power (i.e. imagine if Coca-Cola’s profits fell by half as its stock price declined by half) are much harder to figure out than stock price declines that do not lead to similar declines in profitability.
In the past 100 years, there have been two times when the earnings power of American companies declined alongside stock prices: The Great Depression, and the Bear Market of ’73. Corporate profits fell by around 50% during the heart of the depression, and they fell by a little more than 25% in 1973. Those are difficult environments because you have to anticipate that profits will eventually return to normal someday, but during the 2008 and 2009 crash, the profits at many of the American stalwarts were actually increasing or remaining nearly constant despite the declines in stock prices. That is so much easier to handle than seeing profits dry up by 50% and trying to figure out whether the decline is temporary or going to become permanent. But if you were a diligent investor that focused on the underlying economic engines of the companies you owned, then the 2008-2009 crisis was the opportunity to make once-in-a-generation purchases because the stocks were cheap, and the earnings power remained strong.