Numerous research firms indicate broad market returns over next decade will not be like the last one. Landon Whaley, with some help from Dickens, explains.
“Take nothing on its looks; take everything on evidence. There's no better rule.”
--Charles Dickens
I couldn’t agree more with Mr. Dickens, who would have made one hell of a data-dependent global macro trader. Great Expectations may be the title of a phenomenal 158-year-old novel, but it’s also how I would characterize the attitude U.S. investors have for asset class returns in the years ahead.
Great Expectations
I hope you’ve enjoyed the relentless double-digit gains in the S&P 500 this year, and the above-average returns bonds have delivered over the last 10 years because, according to GMO and AQR, the next five to10 years will look vastly different.
These two well-respected firms are forecasting that U.S. equity returns will be between -2.5% and +4.3% annually over the next five to 10 years. International developed equity markets will gain between 2.0% and 5.1%, they predict, and emerging markets will give you a bit more juice with anticipated returns between +4.7% and +8.2%. In the fixed income universe, U.S. bonds will deliver between -0.7% and +3.1%, depending on the category and the location on the risk curve. You won’t get much reprieve internationally, as those bond markets are only expected to deliver between -2.6% and +2.7% each year. U.S.-based commodities are set to deliver +3.4% each year, and cash is going to earn you a whopping 60 basis points per annum.
These forecasts should be sobering to you. The returns investors have enjoyed across global asset classes, and especially U.S.-based markets, over the last decade have been impressive, but not sustainable. More importantly, it would nearly defy economic and financial market reality to see a repeat of this outperformance over the next 10 years. There is another factor that adds to the bleakness of these forecasts. These are the proposed returns of indices representing various asset classes, and history has shown us that there is typically a wide divergence between returns generated by an index and the returns generated by investors.
“I was too cowardly to do what I knew to be right …”
--Pip from Great Expectations
Each year, DALBAR releases their Quantitative Analysis of Investor Behavior (QAIB) report, which showcases the performance of asset classes over several time frames, and more importantly how investors in those asset classes performed during those same periods. The cliff notes are that the average U.S. equity investor has underperformed the S&P 500 by -1.9% annually over the last 20 years, with the former gaining 5.3% and the latter gaining 7.2%. The underperformance gets even worse on shorter time frames, with investors earning 362 basis points less than the S&P each year over the last 10 years, 486 basis points less a year in the previous five years, and 329 basis points less in the last three years. But this isn’t solely an equity investor issue; fixed-income investors have seen similar underperformance over similar time periods, as compared to the Barclays Aggregate Treasury Index.
You may be thinking that although investors didn’t capture the entire upside of the gains in these asset classes, maybe it’s possible they avoided some of the massive downside experienced, especially in U.S. equities.
“Suffering has been stronger than all other teaching …”
--EstellaGreat Expectations
Conveniently, DALBAR also recently released a study of how investors fared in last year’s market environment, and it turns out that not only does the average investor underperform on the upside, they sustain more losses than the major benchmarks on the downside as well!
It is a tale of two months in 2018 that highlights this rate of return reality: August and October. U.S. markets were rocking and rolling in August, with the S&P 500 gaining a very tidy 3.3%. Unfortunately, the average U.S. equity investor couldn’t keep pace, gaining just 1.8%, which is -1.5% of underperformance. On the flipside, October was a brutal month for U.S. equities as the reality of the FG4-in-Q4 environment started to take hold. The S&P 500 took it on the chin with a 6.8% loss, but the average equity investor saw their portfolio decline 8.0%, another 120 basis points of underperformance. For the 2018 calendar year, equity investors lagged everyone’s favorite benchmark with losses of 9.4% against the S&P’s 4.4% decline, which is nearly 500 basis points of underperformance over just 12 months.
If you read Wednesday’s report, you know I’m not a fan of benchmarking and comparing your returns to that of an arbitrary benchmark. That said, if you’re a U.S. equity investor and you’re routinely gaining only half of the available opportunity set (the S&P’s returns) on the upside and losing nearly double on the downside, there’s a problem with your process
“The success is not mine, the failure is not mine, but the two together make me.”
Now, more than ever is the time to embrace an investing approach that is data-dependent, process-driven and risk-conscious. It’s self-serving as all get out, but I firmly believe the most successful investors over the next decade will embrace two aspects of investing.
First, they will embrace a global macro style of investing. They will look beyond the borders of their own sovereign dirt, scouring the globe for percolating opportunities in not just stocks and bonds, but currencies and commodities as well.
Second, the successful investors of the next decade will go both ways, long and short. The outsized, risk-adjusted returns are earned by those of us who can not only ride a bull market, but who can also opportunistically capture alpha on the short side of markets trading in economies with bearish Fundamental Gravity environments.
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