Back in the ‘80s, legendary stock picker Peter Lynch was famous for looking for those stocks that he thought would grow by a multiple of ten. A “ten-bagger,” he called them. He was simply referring to the increase in the nominal price of the stock, not its real return, measured by the total return over inflation. What nobody realized at that time was that we were on the front end of what has turned out to be the most remarkable stock market of the past century. Indeed, one that would rise nearly tenfold in real terms between 1981 and 2015. One could have simply invested in the broad index and nearly had a ten-bagger in real terms after inflation.
Looking for causality, acclaimed economist Dr. Woody Brock points to five fundamentals that explain stock market returns: 1) aggregate earnings as a share of GDP; 2) the growth rate of aggregate earnings; 3) the level of interest rates; 4) the growth rate of earnings per share; and 5) the magnitude of stock repurchases by firms.
A good question to ask would be what, precisely, caused such an unexpected rise in the stock market. The answer, according to Brock, is that not just one, but all the aforementioned fundamental drivers performed optimally for the stock market for the period in question. All five! This accounts for why nobody in 1981 would have or could have predicted such a rise in the market. Taking the five variables into question, a rational prediction by a normal investor would have been a DOW of 9,000 at the end of 2014, not 17,800. The odds of reaching that level were about one in 3,000 in 1981. That leads us to ask, “What’s next?” Enter the concept of mean reversion.
Nearly everyone today posits a gradual rise in interest rates, both short and long term. Indeed, all eyes seem to be focused on the Fed. Mean reversion also points to a likely slowdown in earnings growth, a reduction in share repurchases as baby-boomers demand dividends over share buy-backs, a reduction in earnings per share, and a reduction in PE ratio back to perhaps a more “normal” 15 from its current 20+. Today, as the market keeps producing new record highs, most people seem to fear an impending stock market crash. However, these mean-reverting developments do not portend a stock market crash nearly as much as they do a sustained lower level of growth. In fact, some estimates call for an equity growth rate that is 60 percent lower than that created by the 1981–2015 regime. Crashes can still occur for quite non-fundamental reasons, and the possibility of one or more crashes should not be totally written off. The real concern may simply be a long-lived lower than expected level of growth.
So what does this say about where we are today, and where we might be headed? Nobody contradicts the demographics that indicate we are on the leading edge of boomer retirements, that pension funds are woefully underfunded, and that it’s soon coming time to pay the piper for the out-of-control profligate deficit spending that has occurred over the past several years. The moral of the story is that it will be very difficult, and highly unlikely, to match the kind of wealth growth we have seen over the past 35 years, just when we need it most.
Long time readers may recall that I like to ask the “So what?” question. Knowing what we have just revealed, what does an investor do now? Indexing stocks and bonds over the past three plus decades has produced extraordinary results. If the prediction above holds true, indexing over the next few decades could become the investor’s worst enemy if he or she hopes to grow a portfolio. Very low or even negative real returns could be the outcome. This should cause us all to rethink active investing vs. passive buy-hold-and-rebalance portfolio management. Over the past six years, it has been so difficult for active managers (stock pickers and active fund managers alike) to beat the index. The drum of indexing is being beaten ever more loudly today as automated advice and management built on indexing is becoming commonplace. Be careful that you do not become mesmerized by the passive drumbeat filling the airwaves and consuming advertising ink. It is likely that high-conviction active management will win the portfolio management battle over the coming decades. We will have more to say about that, as well as behavioral portfolio management, in future articles.
Think clearly about this. Go back to your financial plan and review what real return projections were used to project your wealth and spending power for the rest of your life. Update your plan if the assumptions were based on recent historical averages. Stress test your portfolio. Call us if we can be of help.
The moral of the story is that it will be very difficult to match the kind of wealth growth we have seen over the past 35 years.
Scott Neal is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. He can be reached at scott@dsneal.com or by calling 1-800-344-9098.