The Markets Could Be Ready To Drive Off A Cliff, But Investors Are Looking Only In The Rearview Mirror

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Spoiled by the phenomenal returns of the past 10-years, investors may be looking for annual returns of 10-20% when they should be guarding against the possibility of a lost decade ahead of us.

After a scary start, 2020 has turned into a phenomenal year for stocks. The S&P 500 has continuously broken new highs and is up more than 16% for the year (18% with dividends included). This is only the latest in a string of outstanding years which has pushed the 10-year average return on the S&P to around 14% per year.

The market sentiment can be described as ebullient and very optimistic. Although valuations are uncomfortably high, with vaccines around the corner and continued Fed support, most financial media agree that there is no reason for the rally to end. (Why people pay so much attention to financial media despite their inability to predict past bear markets is a good question to ask). Investors are suffering from a severe case of FOMO and are worried about missing out on more years of 10-20% annual returns.

The reason for the optimistic expectation of future returns is mainly due to excellent past returns. Relying on past returns to predict future returns is a very natural thing for the human brain to do, but it is also wrong. The human brain has evolved to look for patterns (even when there is none) and to weigh more recent occurrences more heavily. Both of these tendencies are normally very helpful in everyday life, but they become fatal behavioral biases in the financial markets.

Here is a real-life example. The follow chart illustrates the average annual returns of a Vanguard index fund with the identity masked.

With nothing else to go on, what do you expect the future returns over the next 3, 5, and 10 years might look like? Take a second or two to actually answer this question before reading on.

Objectively, there is not enough information to answer this question. However, your brain likely has no trouble coming up with expected returns. You might have noticed that both 5 and 10-year returns are in the 7-8% range and thus a 7-8% return might be a reasonable expectation for the long-term. You may have also noticed that recent returns have been improving with 3-year returns averaging 10% and the 1-year return at 18%. Your brain may have latched onto this trend, forming expectations of higher returns of perhaps 10-15% over the near term. With healthy long-term returns and improving short-term returns, this fund sure seems like a promising investment opportunity.

So what is this promising fund? It is time for the grand reveal…. the returns are from the Vanguard Long-Term Treasury Fund. It is a bond fund that invests all its proceeds in long-term US government Treasuries. The unique thing about a bond fund is that we can easily identify the appropriate expected future return. The current yield on the fund is about 1.5%. Thus, if long-term interest rates stay at current levels (which are at historic lows) for the next 10 years, you should expect to earn a measly 1.5% per year. If interest rates were to drop a bit more, the returns could be a bit higher, but nowhere near the 7-8% realized return over the past 10 years. Should interest rates actually rise over the next 10 years, you could easily see negative returns over a decade.

The correct answer to my original question on the expectation of future returns is either 1) there is too little information to tell or 2) if you were somehow able to recognize I was referring to the Vanguard Long-Term Treasury Fund, a range such as -2% to 3% to acknowledge the 1.5% yield and potential movement in interest rates. Yet the natural thing for the human brain looking at past returns would be to guess at a number between 7-16%. Relying on pattern finding and overweighing recent experiences, our brain is all too ready to supply a guess. This guess can clearly be way off. This is the reason performance reports come with the warning “past returns are no guarantee of future results.”

To circle back to the historical returns of the S&P 500, it should be clear that investors expecting double digit returns going forward are basing their expectations on past returns. This is no less dangerous than driving only looking in the rearview mirror.

Unlike bond investors, who must temper their return expectations by the reality check of bond yields, it is harder for stock investors to figure out the expected return of stocks over the next 10 years. This makes it even more likely for stock investors to base their expectations on past returns.

While estimating expected returns on stocks is harder and less precise than for bonds, it is possible. Sophisticated investors should study market history, valuation ranges, GDP growth, historical profit margins, etc. In my estimate, in the best-case scenario, the S&P 500 might reasonably return 3-5% per year over the next 10 years. More likely, the average return could be closer to zero or even turnout to be negative over a decade. This is in part due to our starting point, which is at one of the most expensive valuations in history. This is true whether we are looking at the Schiller PE (price divided by 10-year average earnings) or the ratio of S&P 500 to GDP.

Schiller PE

Thus, over the next decade, valuations are much more likely to contract than to expand, reducing expected returns. Not only are valuations near record highs, the profit margin of the S&P 500 is also at record highs, driven by the improving profitability of large tech companies. With increased anti-trust focus on Amazon, Apple, Google, and Facebook, profit margins are more likely to contract than to expand further from these record levels.

Should profit margins and P/E ratios both contract over the next 10 years, it would produce a double whammy on stock prices and likely result in a lost decade of negative returns. Lest you think this is unlikely to happen, keep in mind that from 2000 to 2010, the S&P lost about 1.5% per year on average.

It is no exaggeration to say we currently face the worst investing environment in our working lifetimes (in terms of expected returns). So what should investors do? I continue to believe investors should take a cautious stance, keeping significant cash on the sidelines and waiting for a better investing opportunity to develop. Continuing with our year 2000 example, the bear market that followed the bursting of the dot-com bubble produced an excellent buying opportunity by 2002-2003.

The end stages of a bull market tend to be characterized by record IPO issuances and high margin debt. US companies raised a record $167 billion from IPOs in 2020, finally surpassing the previous record of $108 billion set in 1999. Even more concerning, more than half of these proceeds came from low-quality blank-check IPOs known as SPACs. At the same time, investors were also borrowing record amounts against their securities with margin debt reaching a new high of $722 billion in Nov 2020.

Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.” There are some scary parallels appearing between 2020 and 2000.


I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The information in the article is provided for informational purposes only. It should not be construed as investment advice or advice on buying, selling, or other types of transactions relating to an investment in products or services, much less an invitation, an offer or a solicitation to invest.

The information in the article is provided solely by virtue of the fact that everyone will independently make their own investment decisions: the report does not take into account investment objectives, nor specific needs or financial situation. In addition, nothing in the article represents or is intended to express financial, legal, accounting or tax advice. You should consult your own investment or financial advisor before taking any actions.

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