One Month. 20 Years. Same Story

Submitted by Nicholas Colas of DataTrek Research

Three points today, 2 focused on the short term and 1 very, very long term:

#1: An update on our “buy the 5% down days” strategy and what it says about the comparison of 2020’s COVID-19 Crisis to 2008’s Financial Crisis in terms of stock market performance:

  • When outsized US equity volatility first started in early March 2020, we proposed a strategy of buying every close on the S&P that was more than 5% below the prior day for risk-tolerant investors with a +1 year time horizon.

  • There were 12 such events in 2008 – 2009. Without knowing how long COVID-19 volatility might last, our idea was to mechanically buy “peak fear” days and average into a position that had a historically good chance (based on the 08-09 experience) of showing a gain in 1 years’ time.

  • So far we have had four +5% down days. They were: March 9th (-7.6%, 2747 close), March 12th (-9.5%, 2481), March 16th (-12.0%, 2386), and March 18th (-5.2%, 2398).

  • The average of those days is 2,503 on the S&P 500, 1.1% above today’s close but 1.9% below where the index traded most of the day. Late day problems with the Senate bill caused a selloff in the last hour of trading.

Takeaway: we’re basically at breakeven on this strategy right now, which is far better than the 2008 experience when it took 9 months to get to flat. That the gains evaporated because of Washington wrangling is, of course, so much like 2008 that we got a flashback to those dark times when we saw the news cross the tape.

#2: While we’re relieved by today’s modest follow-on rally for US stocks, we are also mindful of the following:

  • The CBOE VIX Index remains quite sticky at around 60. During the 2 +10% relief rallies in October 2008 (the 13th and the 28th), the VIX declined noticeably both times.

  • Since we’re running 3-5x normal equity market volatility right now, a 1% move like today is more like “unchanged” than actually “up”.

Takeaway: we continue to like our scale-in approach (point #1) much more than trying to pick an absolute bottom or chasing relief rallies in the hopes they stick. Someone will call the bottom and become “social media famous” for it; it probably won’t be us and we’re OK with that.

#3: At the other end of the investment horizon spectrum, let’s consider what the recent downdraft has done to long run (20-year) compounded annual returns for the S&P 500 and why that matters:

  • Twenty years ago today, the S&P 500 sat at 1,140. With today’s close of 2475, that makes for a 20-year price CAGR of 4.0%. Add in dividend returns (1.8% average) and you get a 5.8% CAGR for the S&P 500.

  • Even if you look at 20-year trailing returns from the February 19th 2020 peak, the numbers aren’t much better: a 4.9% 20-year price CAGR and a 6.7% total return CAGR.

  • Bottom line: when the S&P was making new highs last month, long run returns were still low and now that we’re down +20% from those levels these 20-year CAGRs are even worse.

Think back to the late 1990s, when the S&P 500 had compounded at 18% annually for 20 years, and those 6-7% CAGRs for the last 2 decades look quite paltry by comparison. Yes, inflation has been lower, but that comes nowhere near to closing the gap. And one has to consider that the 6-7% CAGR from 2001 – 2020 has come with 3 sharp drawdowns (early 2000s, 2008, 2020) where the 1981 – 2000 experience was (excluding 2H 1987) much more placid.

Here’s why all that’s important:

Lower equity returns push capital into passive investments. Readers with long memories will recall that the late 1990s was the peak for active US equity management. There’s a good reason for that: you can pay an active manager 1-2% when presumed structural returns are 18% in the hopes of making 25-30%. When they are just 6-7%, every basis point of fees matters.

Lower structural public equity returns encourage institutional asset owners to reallocate capital to alternative investments like private equity and venture capital. Sovereign wealth/pension funds, family offices, and other managers have return targets they need to hit. Public equity returns of 6-7% don’t necessarily cover those, so they 1) index their stock exposure and 2) shift capital to potentially higher return non-public investments. Case in point: according to Crunchbase, from 2010 to 2019 total dollars invested in venture capital went from $48 billion to $295 billion annually.

When you combine lower structural equity returns with bouts of historically high stock market volatility and save-the-baby government policy interventions, investors (especially older individuals) are going to downshift their portfolio risk profile. We’ve seen this happen all through the 2010s, as US mutual/exchange traded money flows saw consistent outflows from stocks (despite a long rally) and into fixed income (despite ever lower yields). Given what has unfolded in recent days, we doubt that trend will reverse course regardless of where US stocks end the year.