Today is the nine-year anniversary of the second longest bull market since WWII. U.S. large cap stocks have rallied about 300% (16.6% annualized). If we include dividends, the gains are 385% (19.1% annualized). Other classes of equity have also performed superbly. U.S. REITs and international stocks have compounded at roughly 18% and 13% per year, respectively. Private equity and venture capital have generated similar gains (returns below are shown net of fees for these two markets - gross returns are far higher). Cash — the sad purple line hugging the bottom of the chart — has been a terrible bet.
The chart below shows nine-year annualized total returns for the last 80 years, rolled monthly. For some context, returns of 18.1% or higher are in the top 10% of historical outcomes. Said another way, they are just as common as returns of 3.2% or less over any nine-year period. The average over the entire 80 years is 10%.
In a recent chart of the week, we shared what we believe has helped drive this epic cycle of risk-seeking behavior and returns. Since the Great Recession, investors have been encouraged to invest in risky assets or suffer a guaranteed erosion of their purchasing power by way of negative real (inflation-adjusted) interest rates. The chart below shows the effective Fed Funds rate — the anchor rate for all short-term interest rates in the U.S. set by the Federal Reserve — adjusted for inflation.
To be clear, we're not suggesting there hasn't been a broad-based improvement in the economy and corporate earnings that justifies higher stock prices, only that we believe the rise in prices has run ahead of these fundamentals partly because of negative real interest rates.
Another reason for the above-average gains in stocks over the last nine years was simply the low starting point. March 2009 was a scary time for investors and financial assets were cheap. U.S. stocks had dropped 58% over the prior 17 months, the economy was in a shambles and sentiment was as pessimistic as it gets. No one wanted to take any risk, let alone in stocks, and prices reflected that widespread gloom.
Public stocks were trading at 0.7x their last 12-month sales and 15x their inflation-adjusted long-term average earnings. The equity in private businesses was changing hands for as little as 6x EBITDA, which itself was depressed. Generally speaking, prices today are between 1.5x and 3x more expensive relative to today’s much higher levels of earnings and revenues.
The chart below illustrates this phenomenon using the last three major bull and bear market cycles (about 35 years). Each cycle shows the progression of several common valuation and sentiment measures with each mapped as a percentage of the lowest and highest readings for the total period. (h/t Semper Augustus for data.)
Of course the peaks and troughs below can only be pin-pointed in hindsight, but the exercise is helpful for setting expectations and managing risk. We don't know if the recent peak marked the end of the stock market rally, but today appears to have more in common with prior peaks than prior troughs.
Investors with the nerve to hold or even invest new cash through the chaos of the Great Recession in early 2009 reaped gains commensurate with the "risk" they took. They acted atypically — contrary to broad public sentiment — and have realized atypical returns. We put "risk" in quotes because the irony of investment risk is that it is highest when it looks most contained and vice versa.
Things today are very different: instead of gloom, optimism reigns; instead of bargains, stocks are more expensive and instead of investors hiding out in cash, cash is shunned. Earlier this year, Schwab reported cash balances for high net worth clients were at historic lows and less than half the levels held in March 2009 (10.8% today vs. 23% nine years ago). TD Ameritrade reported similar numbers. Fidelity too. BAML reported global asset managers had near record low cash levels coming into 2018 (just over 4% vs. the all-time low of 3.4% in July 2007). INTL FCStone reported at the end of last year that cash balances in equity mutual funds were at an all-time low of around 3% (vs. over 6% in March 2009). Per Citigroup, institutional investors held just 2% in cash late last year, compared to over 8% in early 2009.
Is the U.S. economy doing relatively well, is unemployment low and has earnings growth been strong? Yes, very obviously. That's our concern. In this environment, we think it's a mistake to assume stocks will be able to generate the returns going forward that they have in the past, especially not the recent past.
How much should U.S. stock returns estimates be lowered? We don't know what the exact number is (no one does), but we believe returns will be a lot lower than what most investors have become accustomed to... and appear to be positioned for. Yield-based measures, like those used by AQR, suggest medium-term forward nominal returns of about 6% per year (4% haircut to long-term averages). Estimates that assume reversion to the mean of profit margins and multiples, like GMO's, suggest we'll see numbers closer to -3.4% per year (13% haircut). Our own internal estimates point to something in the middle, so low single digits. We should also mention that while many other asset classes are priced to deliver better returns than U.S. stocks, we do not think it'll be by a wide margin.
The chart below attempts to drive this simple point home. For the 5 years after the peak in March 2000, U.S. stocks returned an annualized -5.2% (-3.7% with dividends). Over the nearly 18 years following that same peak through yesterday, they returned just 3.3% (5.3% with dividends). Similarly, for the 5 years after the peak in October 2007, stocks returns an annualized -1.5% (0.7% with dividends). From that peak through yesterday, they returned 5.5% (7.8% with dividends). Starting conditions — the price paid — matter!
Anyone who has lived through a downturn can attest to how difficult it is to take risk, not just because of a lack of willingness but also because of a lack of ability. Investors have a tendency to get over their skis, so to speak, during market booms. Cash balances are drawn down, portfolios are geared up, risk is forgotten. This magnifies the pain of downturns. Investors positioned only for the fun part of the cycle are not able to behave like the long-term investors they claim to be when volatility inevitably arrives. They reassess their situation, maybe realize their risk tolerances were too high, lower them to fit the current situation and de-risk portfolios when they should be doing the opposite. We've seen this done too many times in the name of long-term investing and risk management.
In our opinion, proper risk management should kick in before risk appears. Otherwise what's the point?
For instance, consider a balance sheet managed by a very high profile investor over the last 30 years. Despite public comments by Buffett suggesting stocks are always a good bet and investors should simply dollar-cost average into low-cost index funds over time, Berkshire Hathaway socked about 83% of the $30 billion in cash flow generated last year into cash and cash equivalents. Their $116 billion cash hoard is one of the largest in the world. Berkshire Hathaway now holds more Treasury bills than China or the U.K.
A little over a year ago in Doyle Brunson and the Orange Swan we laid out why we thought the risk-reward for stocks was skewed to the upside:
"The intersection of near-term concerns with a more constructive view of markets over the medium term (2 years) poses a challenge for investors. In response, we are advising clients neither reduce their exposure to stocks wholesale nor increase their exposure given this recent wave of optimism, but rather that they prepare themselves for a market that may run further than many think possible in order to prevent the most damaging mistake of all – abandoning a long-term plan, chasing returns and going all-in near the peak."
Well it looks like everyone is going all-in, which we still think is a mistake.
From our perspective, large numbers of investors are not positioned to be able to withstand any risk, let alone the above average risk baked into a late cycle landscape. In this environment, we think it makes even more sense to maintain your own balance sheet. We like short-duration bonds at current yields for this purpose. We think they have similar expected returns to developed market equities over the medium term and provide added optionality to act as a source of liquidity if there's a market dislocation.
In closing, we'll share a few observations. At the end of January, the Atlanta Fed's GDPNow "nowcast" for first quarter GDP growth was almost 5.5%. As of today, that number has been more than cut in half. While headline inflation has only risen modestly, tight labor markets are beginning to push wage inflation through the economy, which has implications for monetary policy and short-term interest rates. Short-duration bonds and cash proxies have been a terrible bet relative to riskier assets for the last nine years, but that doesn't tell us anything about the future.
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