“Take nothing on its looks; take everything on evidence. There's no better rule.” I couldn’t agree more with Mr. Dickens, and if the whole “writing” thing hadn’t worked out for him, he would have made one hell of a data-dependent global macro hedgie, says Landon Whaley of Whaley Global Research.
Great Expectations may be the title of a phenomenal 158-year-old novel, but it’s also how I would characterize the attitude US 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 and the above-average returns bonds have delivered over the last ten years because, according to GMO and AQR, the next 5-10 years will look vastly different.
These two well-respected firms forecast that US equity returns will fall between -4.9% and +4.0% annually over the next 5-10 years. International developed equity markets will gain between -0.80% and +4.7%, they predict, and emerging markets will give you a bit more juice with anticipated returns between +3.5% and +5.1%.
In the fixed income universe, US bonds will deliver between -1.8% and +1.9%, depending on the category and the location on the risk curve. You won’t get much reprieve internationally, as those bond markets are expected to deliver nothing but losses between -3.5% and -0.60% each year.
It’s anticipated that US-based commodities will deliver +2.7% each year, and cash is going to earn you a whopping 20 basis points per annum. Given the Fed policy trajectory, I’m going to go out on a limb and say that 0.20% is a gross over-estimation of what investors can expect to get paid on their cold hard cash. We’ll be lucky to make it out of the next decade without us having to pay banks for our deposits!
These forecasts should be sobering to you. Over the last decade, the returns investors have enjoyed across global asset classes, and especially US-based markets, have been nothing short of Leaving Las Vegas. More importantly, it would nearly defy economic and financial market reality to see a repeat of this outperformance over the next ten years.
There is another factor that adds to the bleakness of these forecasts. These are the proposed returns of indices representing various asset classes. History has shown a wide divergence between returns generated by an index and the returns earned by investors.
“I was too cowardly to do what I knew to be right…”
Each year, DALBAR releases its 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 US equity investor has underperformed the S&P 500 by -1.9% annually over the last 20 years, with the former gaining just +5.3% while the latter gaining +7.2%. The underperformance gets even worse on shorter time frames, with investors gaining -362 basis points less than the S&P each year over the last ten years, -486 basis points less a year during the previous five years, and -329 bps less during the last three years. But this isn’t solely an equity investor issue; bond investors have seen similar underperformance 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 they avoided some of the massive drawdowns experienced, especially in US equities. As my boy Lee Corso says, “Not so fast, my friend!”
“Suffering has been stronger than all other teaching…”
Conveniently, DALBAR released a study of how investors fared during the tumultuous 2018 market environment, which was the worst year for asset class returns since the 1970s. DALBAR’s research proves that not only does the average investor underperform major benchmarks on the upside, but they also sustain more losses on the downside!
While it was two years ago, this case study is worth a gander as the performance dichotomy of August and October 2018 has replayed several times since then, including this year.
US markets were rocking and rolling in August 2018, with the S&P gaining a very tidy +3.3%. Unfortunately, the average US equity investor couldn’t keep pace, gaining just +1.8%, representing -1.5% of underperformance.
On the flipside, October 2018 was a brutal month for US equities as US growth slowed for the first time in over two years, and the winter fundamental gravity environment took hold. The S&P 500 (SPX) 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!
Regular readers know I’m not a fan of benchmarking and comparing returns to an arbitrary benchmark. That said, if you’re a US equity investor and you’re routinely gaining only half of the available opportunity set on the upside and losing nearly twice as much 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, it is time to embrace an investing approach that is data-dependent, process-driven, and risk-conscious (DPR). 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 beyond the critical DPR foundation.
First, they will embrace a global macro style of investing. Investors 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 like Lane Frost, but who can also opportunistically capture alpha on the short side of markets trading in economies with bearish fundamental gravity environments.
To learn more about Landon Whaley, please visit WhaleyGlobalResearch.com.
