If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail. – John Bogle, May 2017
A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years… We are profoundly worried that this could be a risky allocation over the next 10. – Sanford C. Bernstein & Company Analysts (January 2017)
As a market historian, the price action of the markets today is every bit as remarkable, and I would argue even more remarkable, than the 1996-2002 price action and the 2007-2010 price action, which I somewhat famously forecasted ahead of time. That was a ego boosting timeframe for me, and the opposite occurred when I shorted too early in November 1999.
Circling back to today, popular in-favor stocks like Apple (AAPL), which I wrote a compare and contrast article on recently to one I authored in May 2016, Tesla (TSLA), and Nvidia (NVDA), which I turned bearish on recently too, seemingly march higher nearly every day, despite how preposterous their valuation ratios get, and despite how enormous that market capitalizations become with each passing advance.
Starting valuations matter immensely to future returns, and the rocketing U.S. stock market, and the floating perpetually higher U.S. bond market, have combined to put traditional portfolios at their worst starting point in modern market history.
Look at the projected annual real return table above, and no matter what you think of GMO as an investment firm, they have an undeniable track record as a value oriented manager, including experiencing a very similar episode in the late 1990s, where they called for a similar, yet lesser downturn, and they lost two thirds of their investment clientele for being correct, but too early.
Think about all of the above, and let it settle in, and then consider, how optimistic investors have become about future returns, which is natural given the high return period we have lived through in recent years. Yet this optimism about future returns going forward is unrealistic, and it’s setting up most investors, particularly those near or in retirement, for an epic challenge, as real returns dramatically undershoot expectations.
Investor Return Expectations Are Off The Charts
Earlier this morning, I was doing some reading, and I came across the following table of investor expected returns.
These estimated returns are from a survey by global wealth manager Schroders where they surveyed 23,000 investors during the height of the COVID-19 pandemic in April of 2020.
Breaking down the return expectations by region, North America stands out, as the following graphic illustrates.
Again, the U.S. stock market leads return expectations among investors of the Schroders global survey, with expected nominal returns of 15.4% annually, which could be adjusted to roughly 13% real returns with a 2% annual inflation expectation. Now remember, in the introduction, I outlined how GMO is expecting U.S. real stock returns of -5.6% annually, as of July 31st, 2020, and we have even gone higher in the broader U.S. stock market since that date. Clearly, there’s stark difference between what one of the world’s preeminent value investing firms expects and what most investors expect going forward.
Recapping How We Have Gotten To This Point
(Source: Author, StockCharts.com)
Building on this narrative, the S&P 500 Index returns have been very strong for the past 11 years.
- 2019 – Positive 31.1%
- 2018 – Negative 4.4%
- 2017 – Positive 21.9%
- 2016 – Positive 11.9%
- 2015 – Positive 1.3%
- 2014 – Positive 13.8%
- 2013 – Positive 32.4%
- 2012 – Positive 15.9%
- 2011 – Positive 2.1%
- 2010 – Positive 14.9%
- 2009 – Positive 27.1%
Including this year’s gain of 6.2%, the S&P 500 Index has had a phenomenal steak of performance, leaving the pain of 2018’s 37.2% decline firmly in the rear view mirror.
From March of 2009 through June of 2020, the S&P 500 Index has compounded at a 13.8% rate of return.
Thus, the 13.2% return expectation for North America from the Schroders survey referenced earlier, and the 15.4% expected return in U.S. stocks for the next five years, is a natural linear progression of what also has happened.
The Biggest Stock In The Stock Market Reinforces This Linear View
Apple share have levitated higher, crossing the $2 trillion in market capitalization line just recently, and improbably, it has become a momentum stock at its enormous size.
The annual returns delivered by Apple are out of this world the past 5 years.
- 2020 YTD – Positive 62.2% Year-to-date through 8/20/2020
- 2019 – Positive 89.0%
- 2018 – Negative 5.4%
- 2017 – Positive 48.5%
- 2016 – Positive 12.5%
Again, this is the largest capitalization stock in the market, and it has exhibited the historical percentage gains of a small capitalization equity going through a turnaround or hyper growth phase.
Given how strong these returns have been, in the market’s flagship stock, it’s no surprise that investor expectations for future returns are through the roof.
Closing Thoughts – Look Forward, Not In The Rear View Mirror
Over my two decades of professional experience, and even longer journey as a individual investor, I know all too well that investors chase performance. This ultimately leads to poor returns for investors vs. the benchmark indices as shown below.
(Source: CapitalSpectator.com, Dalbar)
With stock market valuations at historically high levels, and a disconnect between what legendary value investors expect, and what the average investor expects, after a period of very strong returns where sentiment is ebullient, there’s tremendous reason to be cautious and conservative in what your return expectations are going forward.
In the case of a stock like Realty Income (O), which I wrote about recently, it’s virtually impossible for shares of Realty Income to deliver similar returns to what it delivered the past two decades.
Specific to Apple, its shares trade at valuation levels that are at decade highs, according the valuation matrix from Morningstar shown below, and its shares now compromise over 6% of the S&P 500 Index, so almost every investor, whether they know it or not, holds a direct of implicit sizable stake in Apple shares.
In summary, the prevalent overvaluation across almost the entire U.S. stock market, and bond market, has left investors in a precarious position today, leaving investors expecting the best returns going forward, when all valuation-sensitive indicators of future returns suggest they should be preparing for the worst returns going forward.
Ultimately, we remain in a classic bubble, where future real return prospects are dismal by almost any bigger picture valuation barometer, such as market capitalization to GDP ratios. Investors should consider spending research time identifying non-correlated assets, including a higher cash weighting, that might actually diverge from a broader market sell-off, and potentially even move to their own positive valuation drivers, as Antero Resources (AR) has done this year, amidst a very challenging overall investment backdrop. In closing, one of the ironies of ironies, is that many assets, such as large-cap technology stocks, and many yield oriented securities, have moved in tandem on the upside, fueled by the same drivers that may cause them to move in tandem to the downside.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
Disclosure: I am/we are long AR, AND SHORT AAPL, NVDA, AND SPY IN A LONG/SHORT PORTFOLIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Every investor’s situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice.