A Little Bit of Drama
No matter how good my life is, you can always find a little bit of drama. Not that I’m a drama queen, at least I hope not; there’s just always something. Someone is sick; a kid is struggling in school, a conflict with a colleague, or whatever flicker of drama seems to be shining through.
Markets are no different; there is always a little bit of drama and a little bit of spice lingering around somewhere.
Markets have been on FIRE in 2024, surpassing the expectations of all pundits. There is not much to complain about this year, so Goldman Sachs threw a little shade. A little something to spice up life for us financial nerds.
Goldman published a white paper this month concluding that market returns over the next 10-years would most likely be in the 3% range. Furthermore, Goldman submitted that there was something like a 70% chance that bonds would outperform stocks over the next 10 years.
Knowing markets have historically averaged in the 8% – 10% range and have typically outperformed bonds over the decades, you can see how this research could spark a bit of drama.
How do you Figure?
As you might imagine, this article from Goldman and the conclusions presented have invited a lot of criticism.
There is one camp that would agree with these low future return conclusions. These folks would simply point to current valuation metrics (e.g., price-to-earnings ratio) and explain that an elevated valuation relative to history typically results in lower future returns. As I often say, there is a high correlation between current valuations and future expected returns. High valuations (expensive) invite lower future returns and vice versa.
Another camp would refute this conclusion. These folks would argue that when you see examples of these well below-average returns over a decade, they are accompanied by a catastrophic market event (the Great Depression, the Global Financial Crisis, etc.). And, since those events are Black Swans (unpredictable), it negates Goldman’s forecast.
Again, just a little bit of drama and conflict to spice up your life.
This And That
So, who’s right? Neither and both.
That’s a funny answer. Neither are right because they only capture part of the truth, and both are right because when you combine the conclusions, you will land on a more coherent hypothesis.
An old boss always used to tell me, “It’s not this or that. It’s this and that.” It is a way of telling me not to drop one activity or duty in favor of another but rather do both. The advice applies here, too: low market returns need a combination of being overvalued and having a catalyst that resets those valuations.
Multiple Reasons
To fully understand what I mean here, you first need to know where investment returns come from. Stock market returns come from (1) improving profits (earnings) of the underlying companies you are invested in and (2) expanding multiples. Multiples are a way to describe what a buyer is willing to pay in stock price relative to the underlying earnings being produced. Expanding multiples means a willingness to pay a higher price for the same dollar of profits produced. Essentially, happy buyers who are enthusiastic about the future (positive sentiment) are willing to pay more.
What can really destroy this mood or sentiment? A negative catalyst, which deflates buyers’ enthusiasm about paying higher multiples. Something like a financial crisis can absolutely obliterate these multiples, creating massive drawdowns (violent reduction in price), which leads to a lengthy recovery period and muted (or below-average) returns.
Think about it this way. Imagine my almost two-year-old daughter walking around your white carpeted living room while balancing a cup of grape juice on her head. She hasn’t stumbled yet, so no harm has been caused (high multiples), but you realize how dangerous this is, and then her big brother jumps out from around the couch to scare her (a catalyst). The danger and the instigator are both needed to create harm.
Cuts Both Ways
This concept of high valuations accompanied by a catalyst (negative historical event) is the culprit associated with the most underperforming decades.
The opposite is true, too. If you study value investing, a style of investing that targets unloved and low multiple securities, you will find that much of the returns generated with value investing are from improving multiples.
Said another way, improving sentiment.
Imagine you buy ABC company. Currently, most investors think that earnings over the next 5 years at ABC will decline slowly. This would most likely result in ABC company trading at a below-average multiple (price-to-earnings ratio). Then, whether it be a product innovation or, improved business execution or some other positive catalyst, ABC company begins to report earnings that are growing by 10% year over year. Typically, that bump in earnings will result in price appreciation, and these surprise improvements will help reframe investors’ perspective on the company’s future. Let’s just say this uptick in investor enthusiasm expanded ABC’s multiple from 10 times earnings to 12 times earnings. That little bump in sentiment alone would result in a 20% increase in the stock price.
Although my example was fictitious, a thorough study of value investing would show that historical returns (in “value” companies) are driven by both earnings growth and multiple expansions, with the latter accounting for a greater attribution than the former.
Our Only Hope
One key historical fact is that above-average valuations don’t mean reverting according to our schedule or expectations – expensive can stay expensive for a long time. As Keynes once said, “The market can stay irrational longer than you can stay solvent.” A reminder to all of us that valuations alone are not a good timing mechanism.
When it comes to a catalyst, these events are often referred to as Black Swans to infer they are unpredictable—also not a good tool for timing.
So, if I can’t use valuations as a mechanism for timing, and Black Swans are by definition a surprise, what am I to do as an investor? What’s the antidote? Diversification and dividends.
Diversification
It seems to me that most people, at best under appreciate diversification and, at worst, secretly hate the concept.
Three years ago, I couldn’t avoid the question of why we don’t increase our allocations to Real Estate. In the last two years, I can’t believe how many times I’ve fielded the question of why we even own Real Estate. I’ll let you connect the dots on what spurred the differing inquiries.
Investors always want more of what went up and less of what went down. It’s an erroneous shortcut to assume past performance is predictive of future outcomes, yet investors seek that mental shortcut often.
Finance 101 implores us to be diversified, yet most investors want to ignore this truth. BUT, in the long run, it’s often diversification that saves your BUTT. Some catalysts (interest rates, oil prices, demographics, etc.) will have a greater impact on one allocation than another. These catalysts could be positive or negative, so diversification allows you to dilute those sensitivities and make your portfolio more all-weather.
Dividends
Eventually, history has shown that markets have always self-corrected themselves to their average returns. This means that if you look at 20-year rolling periods versus 10-year rolling periods or 30-year rolling periods versus 20-year rolling periods, you will find a shrinking standard deviation. The dispersion of potential outcomes (average returns) shrinks when measuring longer periods.
This reality is great for textbooks but not ideal for a lifetime that only contains so many 30-year periods. You don’t want to put your retirement up to chance by hoping for good timing, you need a more full proof strategy.
The issue becomes when markets are down for extended time periods, and you are also seeking to withdraw monies. We call this sequence-of-returns-risk (SORR). The market deals some of those back-to-back rare and below-average return years, and you are left wondering what to sell, not wanting to let go of an investment for seventy cents on the dollar.
Dividends solve for this. Historically, dividends are less volatile, with a much lower standard deviation than stock prices. By definition, dividends can never be negative. ABC company won’t come knocking on your door quarterly asking you to pay them a dividend. So, you are left with a reliable and consistent source for potential withdrawals. Something that really looks and feels like a paycheck, a resource you could build an actual budget around.
Cheers to the Next 10 Years
So, could we be in for a rough ride over the next decade? Yes, this could be a reasonable hypothesis based on the current landscape.
Valuations are elevated above their historical average, and you will probably find a needle catalyst in the haystack of the next decade.
The best way to insulate yourself from harm here is to be diversified and to be rich in dividends. These antidotes will allow you to avoid needing to time anything or make a gamble on your assumptions, regardless of how strong the probabilities may calculate. This approach will allow you to stay invested and glean the risk premium (returns) that implied risk produces.
So, yes, drama will always disrupt our day, but poise and wisdom are needed to weather the storm. Do your best to operate accordingly.
With regards,
Trevor Cummings
PWA Group Director, Partner
tcummings@thebahnsengroup.com
Blaine Carver
Private Wealth Advisor
bcarver@thebahnsengroup.com
