Guest Post: 10 More Years Of Low Returns

Tyler Durden's picture

Submitted by Lance Robert of StreetTalk Advisors

10 More Years Of Low Returns

sp500-realprice-deviation-041612Ten more years of low returns in the stock market.  If you are one of the millions of baby boomers headed into retirement - start saving more and spending less because the stock market won't bail you out.  Now that I have your attention I will explain why this is the likely future ahead for investors. 

In this past weekend's newsletter I wrote that “If you put all of your money into cash today and don’t look at the market for another decade – you will be better off..."  I realize that this statement is equivalent to heresy where Wall Street is concerned but there is one simple reason behind my apparent madness - the power of "reversion".

This is not a new concept by any means as witnessed by Bob Farrell's rule #1 - "Markets tend to return to the mean over time."  However, the reality of what "reversion" means is grossly misunderstood by Wall Street, and the mainstream media, as witnessed by the many valuation calls that "stocks are now cheap because the market is now trading in line with its long term average."

The power of "reversion" is much more than just returning back to the average (or mean) price level over time.  In reality the movement is far greater.  Let me explain it this way.  If you take a rubber band and stretch it as far as you can in one direction and release it - the band does not return back to its original starting point.  What you will find is that the band will "revert" approximately an equal distance in the opposite direction before returning back to its starting point.  Stock prices and valuations are very similar in this regard as highlighted in Bob Farrell's rule #2; "Excesses in one direction will lead to excesses in the opposite direction." 

In the first chart I have plotted the S&P 500 index on an inflation adjusted basis compared to its long term growth trend.  The area chart below is the most critical to this analysis as it shows the deviation above and below the long term growth trend.  Since 1900, when the market has attained excesses in one direction the reversion process has never, and I repeat never, retraced back only to the long term growth trend before starting a new cycle.  Yet, this is exactly what Wall Street are telling you will happen. 

In the past 112 years each and every reversion process has traveled roughly an "equal distance in the opposite direction" much like the rubber band.  When the market has risen 50% above the long term growth trend subsequent market performance fell markedly until the reversion process was complete.  In almost every case a 50% upside deviation ultimately led to a deviation of 50% to the downside.  As my friend Doug Short eloquently stated"About the only certainty in the stock market is that, over the long haul, over performance turns into under performance and vice versa."  Unfortunately, for baby boomers rapidly approaching retirement, the reversion process that is currently underway still has further to progress which means future stock market returns are unlikely to shore up any shortfall in savings. 

The Reversion Of Earnings

What will drive the continued reversion process.  It will be the next recession which will drive a reversion of earnings.  While Wall Street analysts currently have earnings growth forecasted to rise indefinitely into the future - the reality is that earnings cannot out grow the economy for very long.  The companies within the S&P 500 are a reflection of the economy and not the other way around.  Therefore, if the economy is growing at a sub-par rate then corporate earnings cannot continue to post substantial earnings growth into the future.

eps-gdp-090711In our post "Corporate Profits Are In Trouble"we wrote:  "Don't count on an 8% annualized return going forward to plan for your  investments.  The math tells you otherwise.  Since 1947 GDP has grown 6.6% annually, EPS has grown at 6.7% annually and the average growth of the S&P index itself has grown at 6.6% (not including dividends).   Going forward if the economy is slated to grow at an annual rate of 4%, as hoped by the current slate of economists and Wall Street analysts, then it is going to be difficult to crank out 8% returns in portfolios for retirees hoping to get away with under saving for their retirement.

However, If the next decade of a debt laden economy burdened by high unemployment, higher rates of inflation and lower wages, then economic growth may be more aligned to grow at a mere 2-3%.   If you Include a current dividend yield of 2% plus 2-3% growth in the markets on an annualized basis; it becomes very difficult to navigate through retirement particularly if you were underfunded to began with."

The chart of S&P 500 earnings shows the long term growth trend of earnings.  The reversion cycle in earnings, like the price, is quite apparent.  While the price of the stock market has ranged between a +/- 50% deviation of the long term growth trend line; earnings have swung between a 6% peak-to-peak and 5% trough-to-trough growth rate.  With index earnings currently heading towards the peak of the current cyclical earnings cycle there has already been a marked slow down of year-over-year growth rates.  The phenomenal earnings growth posted from the 2009 recessionary lows was exceptionally strong but unsustainable as earnings have now caught up with the sub-par economic growth rate. 

sp500-earnings-reversion-041612I have plotted out a projected normal reversion of earnings which would currently push earnings per share back towards $60 a share.  Over time the trough-to-trough growth trend will rise but the reversion process, when it occurs, will be very similar to every other previous reversion in the past.  Depending on future Fed market intervention the reversion process in earnings will lead the next economic recession.  That recession is likely to occur late 2012 to mid-2013 sans further stimulus.  Earnings reversions have typically always been followed by the onset of a recession.  (Note: The financial crisis of 2008 took the reversion process well beyond norms but that was also a monstrously abnormal event.)

A Reversion of The "P" And The "E" = P/E Reversion

Are stocks cheap?  The media valuation argument, as discussed, is consistently "based on forward earnings expectations".  There are two primary problems with this argument.  The first is that when valuations are discussed the current level is ALWAYS compared to reported trailing earnings not estimates.  Using forward estimates to make a valuation argument is comparing apples to oranges and reeks of poor analysis.  Secondly, since forward estimates are historically over estimated by as much as 30% - using inflated forward estimates, which are subject to downward revisions, consistently skews the argument.  For example, let's examine the 1st quarter of 2012.  Valuation arguments in October of 2011 were based on an assumption of 10% earnings growth.  Today that growth rate has been revised down to less than 1%.  At the same time market prices have surged in the first quarter driving valuations higher.  What was "cheap" in October is "expensive"  today.

sp500-pe-reversions-041612Furthermore, when arguments are based on improving future valuation metrics, it won't be because earnings are improving faster than the price of the market.  These two components are not detached from one another and the "reversion" process will improve valuations by dragging both the "P" and the "E" lower.

The chart shows P/E valuations using Shiller's trailing reported 10-year smoothed earnings model.  As you will immediately notice the deviation chart looks very similar to the deviation chart of the price of the index.  Valuations, like the price, are well entrenched in the long term reversion process.  With valuations still well above the long term median the real question is whether or not you will survive the reversion process.

10 Years And Loving It

If we look at the reversion process as a whole we can see that the process requires time, a lot of time, to complete.  Currently, we are already 12 years into the current reversion grind and it has not been kind to investors trying to save for retirement.  Assuming that we are in a "normal" reversion process then theoretically we should only have about 5 to 6 years left to complete a normal cycle.  However, given that the current cycle is anything but normal, the reality is that the process most likely has much longer to go.

This got me to thinking about the things we need to consider, as investors, when thinking about saving for retirement and managing portfolio risks.  Here is a list of things to consider.  

  1. "Buy and Hold" investing will not work.   Active management to participate in cyclical upswings, and avoid the majority of downswings, will be key.
  2. "Save More & Spend Less."  Savings will make a large chunk of your total retirement nest egg.  This has always been the case.
  3. "Lump Sum Invest Vs. Dollar Cost Averaging."  Accumulate cash and invest in lump sums when things have become undervalued during the cyclical bear markets.  This will provide better returns over time especially when combined with an active management strategy.
  4. "Income Over Growth."  The income theme will continue to dominate investor psychology particularly in the baby boomer generation.
  5. "The Inflation Benchmark."  The real benchmark for investors to focus on is inflation - not an index.  Inflation, except in rare instances, actually compounds annually - stock markets don't.  Managing portfolios to limit losses and pace inflation will be key to ensure future purchasing power parity. 
  6. "Diversification."  Real diversification between non-corollary assets will be key in the future to hedge off market volatility and reduce emotional mistakes.
  7. "Real Assets."  Investing in physical real assets such as income producing properties, oil and gas wells, precious metals, private equity, etc. will perform better in a rising inflationary environment.  The key here is having a "real asset" behind the investment that will retain value even in deflating market environments.
  8. "Fixed Income"  Even in a rising interest rate environment actual fixed income, not bond funds, will provide income, low volatility and principal protection to portfolios.  Short duration ladders that can ratchet up as interest rates rise will provide portfolios with an edge over long only equity portfolios

Of course, there are many other investments that will do well and these are just a few ideas to start the thinking process.  Furthermore, there will be fantastic and tradable bull market rallies like we have seen twice so far this century.  Being able to capitalize on those rallies will be critical in offsetting the rate of inflation and creating portfolio returns.  Unfortunately, the ensuing declines will also destroy all the gains and then some so being vigilant and disciplined in your risk management process will be critical. 

However, the most important asset destroyed by reversion processes is "time".  It is the one commodity that you have a very limited supply of and no ability to replace.  Reversion doesn't mean that the markets "crash", although they certainly can, but the slow grind through the process will be like "Chinese water torture" for investors slowly destroying valuable assets over time.  Understanding the environment that we are in today, and will continue to face going forward, can help us make better decisions in both our planning and investment process.  Ignore the reversion process at your own risk.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
chump666's picture

Oh dear me...

*USD broadly higher in Asia - with the DXY up around 0.20% since US close

China housing crash assured:

*Based on Reuters estimates, annual house price declines intensified in March versus February (-0.7% y/y vs 0.0% in February).

The China wildcard just flashed.  Wall Street you greedy maniacs, might be wise to start short-selling each other now.  That or a HFT will collapse your sorry a-holes.

We await.

SilverTree's picture

China's `Newly Rich' Gather at Hainan Luxury Expo

chump666's picture

China is such a magnificent bubble.

haha a real estate company did the co report.  "The Wealth Report 2012, published in partnership with Knight Frank LLP."


Retirement?? What's that?

chinaguy's picture

Read Hussman's last few articles...he's come to the same conclusion that a buy-in now will return less 4% annually.

I should be working's picture

Less than 4% annually if you buy and hold 10 years.  But probably another 20% before this bull market is over.

The graph with high and low bars for corporate earnings makes this fact quite clear.  There is no reason to think that earnings will revert to the mean this year.  They will eventually once another recession hits, but even after 1929 another recession didn't hit until 1937 - there was a 5 year bull market in between.  My guess is the current bull has another 1-2 years left before completing the average 5 year cycle.

Government debt is very good for stocks, via the multiplier effect.  What is going to hurt is when the US is forced to balance its budget.  Look at Europe, that's us in a few years.  The alternative is cntl-P to infinity, which will lead to inflation eventually.  And as the 70's taught us, inflation is very bad for stocks.  

If we print to infinity buy gold/commodities.  If austerity is the way to go, buy long dated government bonds.  You can wait out the next bear in those, but I think we're talking 2013 at the earliest here.  We may get another correction if the Bernank doesn't do some more printing soon though...

Bobbyrib's picture

I have to disagree with several of your points. You think a bull market can last another 1-2 years in the current world economic conditions? If real estate bubbles collapse in several countries (that are linked btw) then the stock market in the US will most likely correct. I doubt the US stock market can avoid a correction if the rest of the world has economic problems. To think we could just coast along is ignorant and arrogant.

"If austerity is the way to go, buy long dated government bonds.  You can wait out the next bear in those, but I think we're talking 2013 at the earliest here."

This is the second point I disagree with. Eventually we will have to start giving haircuts to government bond holders not named "The Federal Reserve" being that the debt the country has taken on is unsustainable. Government bonds will probably be the worst buy of the century. When interest rates eventually rise, the highest rated corporate bonds will probably be the better buy (depending on market conditions).

devo's picture

Expect book cookin'

NOPOMO's picture

Well it was not cheap at DOW 6000 or S&P 666.  Simply printing USD to force the rally does indicate any prosperity.  Let those that caused the crisis, take their lumps or we will have no chance a recovery.  It is clearly desperation and for that we will not participate.

I should be working's picture

Of course it was cheap.  It's just that valuations don't matter during a liquidity crisis.

ghostfaceinvestah's picture

Your single best return these days on a risk-adjusted basis is paying down any and all debt, including your mortgage (unless you are underwater and the default put option is worth tens or hundreds of thousands).

Paying down debt is also the single best way to hurt banks.  Debt IS their product (it ain't checking accounts that make them all their money).


tocointhephrase's picture

Thats the best case. At least another 10 to go imho

in4mayshun's picture

I don't understand why the author is discussing "long-term" investing  strategy. With a US credit default and the end of the petro-dollar in the works, how could anyone even attempt to imagine what the future of the stock market will be?

SAT 800's picture

Me neither. It's absurd. Ten years of low returns? how about no returns starting next year? That looks more likely to me. In other words, the future has been cancelled due to lack of interest. (Interest on the debt).

q99x2's picture

Maybe he posted to the wrong site.

We just like to watch what happens to guys like him.

lasvegaspersona's picture

slow news day at ZH, can't find anything to get me riled or even interested, even Krasting struck out.

Amagnonx's picture

If by 'cash' you mean silver, gold or some other commodity then I'd agree - if you mean put all your money in fiat then .. not so much.

Orly's picture

Thanks, Lance.  Keep up the good work.


nolla's picture

The article has some good long term fundamental charts and statistics but also some obvious black holes.

First, he seems like talking about real GDP growth (higher inflation was referred to), but nominal EPS growth. You can't compare apples to oranges. Maybe the time series are too long since you'll get some strange end results, like GDP growth is unnaturally close to EPS growth. Still, not sure what that 6,6% GDP growth since 1947 is. Nominal or real? Anyway, "higher future inflation" means different things to GDP and nominal EPS growth. Take a look at Zimbabwe...

Secondly, he wants the reader to comprehend that (nominal) EPS can't grow any faster than (real) GDP. Economics 101 tells us that corporates can leverage their balance sheets in order to (leverage) their equity. That's why nominal EPS can and will grow faster than GDP over time.

Not that I don't expect the SP500 EPS to drop to 80 before this secular bear is over. 

Bobbyrib's picture

The real inflation rate is also higher than GDP rates. There is little to no organic growth in our economy.

orangegeek's picture

10 more years of low returns.  I guess that's what you get AFTER the market collapses - wave 3 down for all you elliott wavers.


Check out the SP500 and Dow here - not pretty.

Getting Old Sucks's picture

Years ago when the Boomer retirement scare initiated, I wondered what effect retiree draw down of assets would have on the markets.  I wondered how TPTB would try to keep Boomers in the ponzi.  This was back in the mid-late 90's.  I thought to myself that ok, we don't produce much here anymore; we spent 50 years capitalizing on the rest of the world and turned it inward on ourselves because the rest of the world woke up to our scheme.  There's no doubt in my mind that TPTB will try their best to control a slow, drawn out Boomers asset draw down. 

Sheepfukker said above "Retirement?? What's that?".  TPTB has succeeeded in a way to keep many Boomers working out of fear of not having enough to retire.  There are a large percentage of Boomers who wouldn't have had enough anyway, but TPTB aren't directing this mindset towards them.  They want to keep those who have enough, fearful that they may not have enough, working.  The housing crash actually helped their cause as it stripped away a good chunk of Boomer assets that along with some savings and SS would had produced enough to retire.   Those who had housing assets, but no savings now have to delay retirement.  However, those who have enough assets and collectively a very large part of the markets are still the problem.  Those early Boomers are going to retire.  TPTB have to figure out a way to keep as many late Boomers as they can in the game.  SS reform will help but judging past political experience, by the time enacted, chances are that late boomers will slip by the open gate. 

So, between pension fund and individual draw downs for Boomer retirement, the markets will get a lot smaller over the next decade, IMO

Sandmann's picture

I thought it was Wall of Money that created the Boom anyway. Once the Retail Investors pull out of the Market there is noone to fleece so dark pools have to be careful and 33% trades are now dark pools