“Expect lower returns and rocky markets for the next 2-3 years.”
> Joe Davis, Global Chief Economist, Vanguard Group
I’m writing to you from Chicago where I am attending the Morningstar ETF Conference. Vanguard’s global chief economist, Joe Davis, kicked off the event Wednesday evening advising investors to expect lower returns and rocky markets for the next two to three years. That theme is not new news, but it may feel like “fake news” to many an investor given the 10% move year to date in the S&P. My favorite session was Barry Ritholtz’s interview with behavioral investment expert Professor Richard Thaler. Thaler’s dry wit and fun humor was a real treat. I’m going to try to track down the audio and/or video link for you. Look for it in next Friday’s post.
Speaking of forward returns, as we do early each month, let’s again take a quick look at the most recent valuation metrics and see what it tells us about coming 7-, 10- and 12-year returns. While not perfect, it is hard to ignore the historical correlations. “Expect lower returns and rocky markets?” With record low volatility and markets turning its head to nuclear, geopolitical and levered bets, I believe the average investor is expecting 10 percent, not two.
The following two charts illustrate the secular bull and bear markets since 1900 reflecting both nominal and real (after inflation or deflation) returns. The idea here is to see how markets behave over time. As I’m sure you’d conclude, they cycle. Here’s a look:
Chart 1: Since 1900 Bear Markets Have Occurred Nearly as Much as Bear Markets
Here is how you read the chart:
Bull Market Regimes:
- There have been five secular bull market cycles since 1900.
- Gains varied with the best performing period gaining 24.9% annualized per year. The period occurred from 1921 and peaked in October 1929.
- The lowest annualized gains — 8.5% — were at the turn of the 20th century, March 1900 to January 1906.
- Most of us recall the great bull market, the 18-year period from 1982 to 2000, which produced annualized returns of 16.8% and the current bull market from the great financial crisis low to present, producing 15.3% annualized gains.
- The longest secular bull market lasted nearly 24 years (1942-1966).
- The shortest lasted six years (1900-1906).
Bear Market Regimes:
- There have been four secular bear market cycles since 1900.
- All secular bear markets produced negative annualized returns with the worst period, 1929 to 1942, returning a negative 10.6% annualized return. Compound your money at -10.6% per year for 13 years and your $100,000 turns into $23,302.
- 1966 to 1982 was a different secular bear experience. While the decline over the 16-year period was -1.1% annualized per year, it was a period that experienced high inflation. Therefore, while $100,000 declined to $83,645, after factoring in real after inflation return of -7.9%, $100,000 declined in spending value to just $26,801.
- The average bear market decline is -38%.
- The last two bear markets, 2002 and 2008, saw the S&P 500 Index decline by more than 50%.
- Such declines tend to come during recessions. To which end, equities tend to be an excellent economic indicator. (That’s where trend following can help.)
Source: Ned Davis Research
The next chart provides long-term historical perspective on the U.S. equity market, looking at both nominal stock prices and real (inflation-adjusted) stock prices. It identifies the long-term, “super-cycle” periods in the market that we call secular bull and bear markets. Secular trends are long-term periods of 10-25 years that can encompass shorter-term cyclical bull and bear markets.
The same is true across all asset classes. Here is how you read this next chart:
- The top section looks at the S&P 500 from 1900 through August 31, 2017.
- The shaded green areas are the BULL markets. Also shown are the annualized returns over the period.
- The shaded white areas are the BEAR markets with annualized return numbers.
- The data box (red arrow) shows the GPA, or gain per annum, for secular bull and secular bear periods. Also shown is the percentage of time in each secular period over the length of the study.
- The middle section looks at yields of long-term U.S. government bonds, while the lower section looks at the commodities market as measured by the NDR Commodity Composite.
Chart 2: 54% of Time in Bull Markets vs. 46% in Bear Markets Since 1900
Source: Ned Davis Research
When one takes a step back and looks at full market cycles, the need for navigating secular trends becomes apparent. This is true for all asset classes.
In this week’s piece, you’ll find the most recent valuation charts (high) along with the forward return statistics (low to negative). What I try to do is simply handicap risk and reward so I know when to allocate more aggressively to equity market exposure and when to underweight and hedge.
Today, risk is high yet the market may go higher. As you’ll see in the latest Trade Signals post (link below), the equity and fixed income trend indictors continue to point to a modestly bullish forward view. And gold has broken to the upside. I suggest a few ideas around portfolio structure below.
So grab a coffee and take a look at the valuation charts and forward return data that follows. And do feel free to share them with your clients if you find appropriate. Expecting 10% in a probable flat-to-negative return environment is a mismatch that will cause behavioral problems. Who needs advice when you can buy the S&P 500 for next to nothing? I believe your clients need you now more than ever.
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Included in this week’s On My Radar:
- Valuations and Probable 7-, 10- and 12-Year Returns
- Recessions by Decades – Will This be the First Without One?
- Trade Signals – Secular Bull Markets Occurred Just 54% of the Time Since 1900
- What Do You Do?
- Personal Note
Valuations and Probable 7-, 10- and 12-Year Returns
Chart 1: GMO’s 7-Year Real Return Forecast
Here is how you read the chart:
- Take two Advil
- Drink heavily
- -4.2% compounded annually for seven years means your $100,000 is worth the inflation-adjusted equivalent of $74,056. Consider, too, the seven years of lost income on that money.
- An unpleasant bump in the long-term road of a dollar cost averaging 30 year old. A retirement game changer for the pre-retiree or retiree.
To better understand how GMO calculates their forward return outlook, see GMO’s “The S&P 500: Just Say No” for the quant geek explanation of how GMO comes up with the forecast. You can find it here.
Bottom line: GMO has been posting their monthly real return forecast for a very long time. Study the data, as others have, and you’ll find a near 0.97 correlation between what they predicted