Client Memo: Future Returns Look Downright Abysmal. What Do We Do About It?
Nov 04, 2024I’ve been on this bandwagon for some time now but as the market zooms, we have to wonder what future returns will look like. The S&P 500 is on pace for its second straight 20%+ annual return. This has only occurred five times over the last 75 years, per Bloomberg.
20%+ returns in the market in any given year are actually fairly common happening 40% of the time. Two of them came in the 1950s, and as far as the magnitude of the gains, these were the most impressive periods, with gains of 32% and 24% in 1950-51, and then 53% and 32% in 1954-55. The next came in 1975-76, then again in 1982-83, followed by the tech bubble-phase in the late-1990s.[1]
What is driving that strong performance?
It has been powered by a still growing economy that is the envy of the world and shows no signs of slowing down, a Federal Reserve cutting interest rates, and strong corporate profits. But one cannot exclude the artificial intelligence (“A.I.”) euphoria as well.
Investors are buying into this market on the theory that A.I. would bring massive productivity gains sparking higher-than-trend economic growth for the foreseeable future. This is not unlike the 1990s when the internet was billed to do the same thing.
But like any disruptive technology, there will be winners and losers. We are in the early innings and the companies that provide the picks and shovels to the A.I. trade have been the big winners so far, namely Nvidia which is really the only company that can provide the chips that power these A.I. large language models.
At a conference recently, I heard a comment from a bond fund manager that stuck with me. He said that the peak for electricity stocks was 1911, well before most of the US population even had electricity.
His point being that the A.I. stocks will run higher well before there are the profits to justify the rise but like in the early 2000s, the market will correct for the winners and losers. How many dot.com stocks vanished from 2000 to 2003?
What does the S&P 500 typically do after two years of 20%+ gains?
The chart below shows what the third year looks like in the five instances of 20%+ returns in the S&P 500.[2]
What happened after the strong market returns of the 1990s? We had a “lost decade” with almost no real returns for stocks during the 2000s. That, of course, doesn’t mean we cannot have some strong years (we had a big up year in 2003 and again in 2009 but those were coupled with a lot of bad years including 2002 and 2008.
Over the long term, the market generates returns of 8% average annual nominal returns or 10% when you reinvest dividends.
Periods when the market generates returns above that trend tend to be followed by periods when the market produces below average returns. This is called the reversion to the mean.
Goldman Sachs recently published a new note forecasting a 3% average annual return for the S&P 500 over the next decade. They base this on starting valuations, the large market concentration, lower corporate margins, and higher interest rates.
During the 2010-2020 period, when rates were near zero, stocks had no competition. There was an acronym called “TINA” or There Is No Alternative. With bonds yielding next to nothing, investors were forced into stocks to earn decent returns.
Today, that is not the case. Bonds offer up compelling yields that we haven’t seen since the Financial Crisis providing competition for stocks.
The chart below is a little wonky. What it shows is the S&P 500 valuation on the x-axis (horizontal) and the returns over the next decade on the y-axis (vertical). You can see there is a relationship between the two given the tight clumping of the dots along the dotted (lease squared) lines.
What this shows is the difference in future returns at different levels of valuation for the market. For example, the red dot for September 2024 (today’s valuation level) implies just a 2.2% annual return per year for the next decade, according to this model.
Conversely, in February 2009, after the terrible year for the market in 2008, the market traded under 6x P/CF which you can see corresponds with a 19% annual return over the next decade.
In part II of this memo, I will detail what we are doing about this. There will likely be a reckoning at some point in the next decade, likely around our country’s fiscal posture. To reduce spending, and right the ship, we have to slow GDP growth down. That could cause a significant repricing of risk assets.
Until then, we will be prudent with your hard-earned assets and protect them in the best means possible.
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Sincerely,
Mark J Asaro, CFA
Noble Wealth Management
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