Topics: Individual investors are the most bullish at the wrong time. GMO expects -8% annual stock market returns and signs that we are in the endgame.
September may have ended on a bit of a sour note, but the market was still making new highs less than 30 days ago. The S&P 500 is still up 15% year to date despite rampant inflation, significant risk of higher interest rates in the coming years, a reduction in fiscal stimulus compared to the past year, and disruptions caused by the Delta variant. Investors have on some pretty rosy glasses indeed.
Dreaming of Castles in the Sky
After more than a decade of phenomenal returns, investors have been lulled into thinking double-digit annual returns are the norm. Some may be thinking it is a birth right. Natixis Investment Managers conducts an annual survey of global investor expectations. Their 2021 report surveyed 8,550 global investors. The following chart from Natixis shows that investor expectations for annual returns had been climbing gradually from 8.9% in 2014 to 10.7% by 2019 and took a step function jump to 13.0% in 2021. These are real return expectations after subtracting out inflation. Nominal returns, after adding back inflation, are expected to grow 14.5% per year.
The Natixis survey also included 750 U.S. investors who expected U.S. stock market returns of 17.5% per year going forward!
If you can’t tell, I don’t think 17.5% returns going forward for the U.S. stock market is at all realistic. What is a more realistic expectation? You may recall hearing somewhere that the long-run return of the U.S. stock market is about 10% a year. While that is largely true (it is actually closer to 9%), we don’t live in an average market. We live in one of the most expensive markets in history. If you need a refresher on why expensive valuations are associated with low future returns, see my Q2 market commentary.
GMO’s 7-Year Asset Class Real Return Forecasts
One of the most respected market historians and investment managers is Jeremy Grantham. His firm, GMO, puts out a periodic forecast of annual real expected returns for various asset classes over the next 7 years. GMO’s forecast for the US stock market is a downright gloomy -8% per year. These are real returns, so we have to add back 2% for inflation to get to nominal returns. However, a -6% nominal return is not much of an improvement.
While a -6% annual return may seem difficult to imagine, I actually think it has a higher likelihood of happening than a 17.5% annual return going forward. Rather than trying to predict a specific number that implies much more precision than there is, I think a range is more appropriate. If I had to guess on the annual return over the next 7 years, I think a range of -5% to +3% is likely. This is not as gloomy as GMO’s forecast, but it is still not a happy outcome for taking stock market risks.
A Baseball Analogy: Extra Innings
You will often hear the warning that you can’t time the markets. And that is true. No one can say for sure whether the bear market will start this month or next or even this year or next year. However, you can and should be cognizant of where in the market cycle you are.
A baseball analogy is helpful here. Baseball is played over nine innings and the team with the most runs (points) at the end of the ninth inning wins. However, if the game is tied after nine innings, the game goes into extra innings. If the game is still tied after the first extra inning, additional extra innings are played until one team pulls ahead. So once a game goes to extra innings, you know you are close to the end, but you have no idea of how many innings it will take to actually determine the winner.
Trying to time the market (figuring out exactly when the peak is) is like trying to figure out in which specific inning the baseball game will end. It is impossible to predict. However, just because you can’t predict which inning the game will end doesn’t mean the game will go on forever. The very fact that the game is in extra innings tells you it could end at any moment.
After a 12-year bull market and with the market at extreme valuations, the stock market has also gone into extra innings. It is impossible to tell which year (inning) the bull market will end, but it would be reckless to have all of your money invested in stocks and bet the bull market continues indefinitely.
In baseball, there is a convenient score board that tells you exactly which inning you are in. In the stock market, there are no score boards to tell you what inning you are in, but there are signs you can use to identify whether you are late in the market cycle. Towards the end of a bull market, you typically see record IPO issuance, record merger and acquisition activity, and rampant risk-taking and excessive trading by individual investors.
Just over the past few days, I came across the following articles:
Wall Street Revels in the Biggest IPO Boom in Decades (CNN Business)
- What’s happening: In the third quarter, which wraps up Thursday, 94 US initial public offerings, or IPOs, raised $27 billion. That makes it the best July-to-September period by deal count since 2000, according to a report from investment bank Renaissance Capital.
- Globally, 2,044 new listings have brought in roughly $468 billion year-to-date, per Dealogic data compiled for CNN Business. That’s already surpassed a record-setting 2020, when 1,656 deals raised almost $358 billion.
Corporate-Buyout Loans Near Highs of 2007 (Wall Street Journal)
- Companies have issued $120 billion of “leveraged loans” this year through Sept. 23 to finance corporate buyouts by private-equity firms—just shy of the $124 billion record for the first nine months of the year set in 2007, according to data from S&P Global Market Intelligence’s LCD.
- “I’ve signed eight deals since June and in a typical summer I average one per month,” said Elizabeth Cooper, a partner at Simpson Thacher & Bartlett LLP who frequently advises on leveraged buyout deals for private-equity firms like Blackstone Group. “I don’t think I’ve taken a day off—a full day off—since Christmas of last year,” she said.
- A mix of government policies have primed the LBO frenzy. Easy money and low interest rates have pushed investors toward the high yields that leveraged loans pay. Meanwhile, company owners are trying to cut deals ahead of anticipated tax overhauls.
- Purchase prices and debt loads are climbing amid the boom, raising concerns that when economic growth slows, the companies being bought won’t be able to repay the loans private-equity firms use to buy them, bankers and credit investors say.
Pandemic Recovery Fuels Deal Craze As Third-Quarter M&A Breaks All Records (Reuters)
- A frantic summer of merger activity produced deals worth $1.52 trillion in the three months to Sept. 27, up 38% from the same quarter last year and more than any other quarter on record, according to Refinitiv data.
- Third-quarter volumes drove global M&A activity in the first nine months of 2021 to an unprecedented record of $4.33 trillion, overtaking an all-time annual peak of $4.1 trillion hit before the financial crisis in 2007 and forcing investment banks to hike pay for overworked and disgruntled junior staff.
Individuals Embrace Options Trading, Turbocharging Stock Markets (Wall Street Journal)
- “I had no idea what options were last year,” Mr. Patel said. “You can make quick 100%, 200%, 300% [gains] within minutes if things go your way.”
- “I’m hooked on the options,” said Britt Keeler, a 40-year-old individual investor based in Winter Park, Fla. “You could lose it all really quick but you could hustle and kinda hit the jackpot.”
- Nine of 10 of the most-active call-options trading days in history have taken place in 2021, CBOE Global Markets data show. Almost 39 million option contracts have changed hands on an average day this year, up 31% from 2020 and the highest level since the market’s inception in 1973, according to figures from the Options Clearing Corp.
- By one measure, options activity is on track to surpass activity in the stock market for the first time ever. In 2021, the daily average notional value of traded single-stock options has exceeded $432 billion, compared with $404 billion of stocks, according to calculations by Cboe’s Henry Schwartz. This would be the first year on record that the value of options changing hands surpassed that of stocks, according to CBOE data going back to 2008.
So there you have it. Record IPO issuances—check. Record merger activity—check. Record option volume driven by retail investors gambling with leverage—check. This doesn’t tell us exactly when the game will be over, but it sure seems to me that all the signs are pointing to the market being in the endgame.
Given the poor expected returns for the U.S. stocks as a whole, how should investors position themselves? At Think Different Wealth Advisors, we are taking a two-pronged strategy. First, we are maintaining much higher levels of cash than we would in a normal market. We want to maintain plenty of dry powder so we can “back the truck up” when the inevitable market selloff does occur.
Second, markets are not uniform and there are always opportunities to be found somewhere. Even as most US companies remain near all-time highs and sport nosebleed valuations, the recent selloff in Chinese stocks is presenting an increasingly attractive buying opportunity. We are actively researching the Chinese tech giants, some of which are down 50% from their previous peaks. There is plenty of fear about regulatory uncertainty and a slowing Chinese economy. We like that. The time of maximum pessimism has always been the best time to buy.
Be fearful when others are greedy. Be greedy when others are fearful.Warren Buffett
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