Via Zerohedge

Submitted by Nicholas Colas of DataTrek Research

Even with a strong 2019, trailing 20-year returns for the S&P 500 are some of the worst in the last +90 years. What do the next 2 decades hold?

With just days to go in the decade of the 2010s, the S&P 500 is up 250% on a total return basis from December 31st 2009, compounding at an average of 13.3%/year. How does that compare to history? Here is the data going back to the end of 1929 (link to source material below):

  • 1930s: total return of -8.9%, compounded annual growth rate (CAGR) of -0.9%

  • 1940s: +126%, CAGR of 8.5%

  • 1950s: +492%, CAGR of 19.5%

  • 1960s: +111%, CAGR of 7.7%

  • 1970s: +78%, CAGR of 5.9%

  • 1980s: +395%, CAGR of 17.3%

  • 1990s: +426%, CAGR of 18.0%

  • 2000s: -9.0%, CAGR of -1.0%

  • Average of these decades: 201% total return and a CAGR of 9.4%.

So, yes… the 2010s were good – better than the average decade – but:

  • It came after the worst round-number decade in measured history (the data here starts in 1928).

  • And it pales in comparison to the post World War II period (1950s) and the long expansion from 1980 to 2000.

  • The math here also ignores inflation, which silently compounds at positive rates regardless of what stock markets do.

In short, a decade of headline performance data is a noisy measure of long-run stock returns, which is why our approach is to look at 20-year returns on both a nominal and real (inflation adjusted) basis. A few points to expand on that thought:

  • Unlike 10-year timeframes, the S&P 500 has ALWAYS generated a positive return over any trailing 2-decade period going back to 1948 as an endpoint. This is true on both a nominal and real basis.

  • Put another way, 20 years is pretty much the shortest period of time necessary to own US stocks and be assured of a positive real return. There are 2 instances, with end points of 1949 and 1982, where CAGRs showed less than a 1% real return but at least they were positive.

  • Rolling 20-year historical CAGRs from 1948 – 2019 do still show wide variations in return profiles.

    For example, over the 20 years ending in the early 1960s or late 1990s, US stocks compounded at better than 15% annually. That means they doubled in value every 5 years. Adjusted for inflation, the CAGRs here were still +12% in those timeframes, so shareholders saw a doubling of real value every 7 years.

    Conversely, there have been long stretches where US equities compounded at much lower rates, like the 20 years ending in the early 1980s or the most recent 2 decades. Here, nominal CAGRs of 5-7% only yield a doubling of value every 11-15 years and real CAGRs of 1-3% means less than a 2x return over our 20-year window.

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There is a chart with all the data below, and through its lens we see several important issues:

#1: Boom times come against very specific macro backdrops…

  • From 1942 to 1961 the S&P 500 compounded at 16.7%, the best result until the late 1990s. The causes of that run: 1) the Allies’ victory in WW II 2) America’s still-intact post-War infrastructure and 3) remarkable US demographic and economic growth in the 1950s.

  • The only better run – 1980 to 1999’s 17.7% nominal return – stemmed from Paul Volcker’s successful efforts to tame inflation (with commensurately lower interest rates/higher equity valuations over time) and the 1990s’ stock market bubble created by enthusiasm over Internet 1.0.

#2: … And so do periods of low structural returns:

  • Holding US stocks from the late 1920s through the dawn of the 1950s yielded just low-single-digit long run returns in both nominal and real terms. That’s not the fault of the 1929 Crash per se: stocks were only down 8.3% that year. Rather, it was the Great Depression that hit equities. If you bought the dip at the end of 1929, you weren’t whole on a nominal basis until the end of 1936. Inflation-adjusted, you didn’t get back to par until 1942.

  • And, believe it or not, the 20 years ending 2018 was similarly bad, compounding at just 5.6% nominal (the worst since 1930 – 1949) and 3.4% real (worst since 1970 – 1989 due to record high US inflation). The reason: 2 stock market bubbles bursting, the first in Tech stocks and the second in US housing. The second, of course, caused the Great Recession.

#3: This latest period of low returns have fundamentally remade capital markets:

  • Investors anchor expectations of future long-run returns on the recent-ish past (like the 20-year horizon we’re looking at today).

  • They are logically reluctant to pay for active management if expected structural returns are low. That’s why passive investing has boomed in the last 20 years, which coincides exactly with the decline in 20-year trailing CAGRs from 18% in 2000 to 6% now. You can’t pay an active manager 100 basis points if you think future returns will be 6%…

  • On top of that, asset owners will look for alternative, non-public equity opportunities to offset expected lower future stock market returns. Enter the growing popularity of private equity and venture capital over the last decade. This phenomenon also partly explains the recent enthusiasm for assets like crypto currencies. Any port in a low-return storm…

  • Investors will also seek to hedge their equity market exposure the longer a bull market continues. As we wrote recently, the CBOE SKEW Index (the cost of insuring against “tail risk”) took a step function increase in 2014 and hasn’t really looked back since.

  • Lastly, investors who still need a 10% return from equities (basically the very long run average) will tend to add beta to their portfolios to juice performance. Over the last 5 years, that has meant owning as much Technology as one can reasonably bear.

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Now, the $64 question: what does the next 20 years hold for US stocks? A few thoughts:

#1: We can safely exclude a repeat of the decline in interest rates that aided domestic equities during their long bull run in the 1980s/1990s. Ten-year Treasuries yield just 2%, not the +15% of 1981. And Europe’s recent experience with negative rates shows these don’t help equity valuations.

#2: We also start the next 20-year cycle with relatively high US equity valuations. This is one place (maybe the only one) where the Shiller “Cyclically Adjusted PE Ratio” (CAPE), based on trailing 10-year actual earnings, can inform an investment discussion:

So what prior periods does the current CAPE of 31 resemble? Using start-of-year numbers, here are the 2 most relevant comps:

  • 1998’s 33x, with future 20-year CAGRs of 7.1% nominal and 5.0% real.

  • 1929’s 27x, with future 20-year CAGRs of 2.4% nominal and 0.6% real.

Worth noting: that 7% CAGR from the late 1990s looks pretty good, but one must remember that 10-year Treasuries yielded 5% at the start of 1999. We’ve had a nice valuation tailwind over the last 2 decades as yields have declined. As noted in the prior point, that is unlikely to recur. On a more positive note, the 1929 comp is (hopefully) irrelevant for all the historical reasons noted above.

#3: Valuations and future returns share one common driver – sustainable corporate reinvestment rates (both in terms of marginal returns on capital and total incremental capital deployed):

  • The growth in stock buybacks during the current cycle has been helpful to equity returns. According to S&P, well over half of the 500 (334 companies) have fewer shares outstanding now than a year ago and almost a quarter (115 names) are down on share count by at least 4%. In one year…

  • On the plus side, that keeps corporate reinvestment rates at the cost of equity capital and supports high valuations. On the downside, companies have taken advantage of low interest rates to lever up, essentially playing an arbitrage between yields and their equity cost of capital. That only works until a recession, which drives operating cash flow lower.

  • Since so much of the S&P 500 is the Tech sector plus Google, Facebook and Amazon (31% in total), these companies’ future reinvestment rates are central to any discussion of how the next 20 years will play out. If you can tell a story about how Apple or Microsoft will have $5 trillion market caps in 2040 – a 7.4% CAGR from their current $1.2 trillion valuations – then you have a philosophical pathway for similar gains for the S&P 500. That would require each to climb even further from their already-commanding heights with new technologies and services, of course. But that’s what reinvestment rates measure… 

    Alternatively, one might believe that the next Apple, Microsoft, Google or other disruptive technology is currently sitting in some venture capitalist’s portfolio right now and will eventually IPO. It might be a quantum computing company, or one that has an edge in artificial intelligence, or a promising biotech startup with a cure for cancer or the key to eternal youth. All would offer fantastically high returns on capital and opportunities for large-scale capital investment.

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Where we come out: we do think US equities can post 10% compounded returns over the next 20 years, inline with their long run average, even though our 2020 valuation starting point is certainly far from optimal. To be right, all we need is for the American engine of innovation to maintain its historical global preeminence and productivity. The low equity returns of the last 20 years has forced money into venture capital at unprecedented rates, which is our ace in the hole for this argument. Even if much of that capital will end up in the dustbin (it always does), there’s more than enough to fund the next wave of economic growth and sustainable corporate earnings and return on capital.

Sources: Long run historical S&P 500 returns (courtesy of NYU professor Aswath Damodaran):  http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html; Shiller PE:  https://www.multpl.com/shiller-pe