The Dark Decade (Or The Investment Renaissance)

by: Eric Parnell, CFA

Stocks are expensive.

If history is any guide, a dark decade for stocks may lie ahead.

A decade of darkness or an investment renaissance?

Stocks are expensive. Yes, we can debate at length about whether today's premium valuations are justified or not. But they are still expensive today. And if history is any guide, this does not bode well for stock market returns in the decade ahead. But just because the stock market itself may not be setting up to do well over the next decade is not necessarily a bad thing. In fact, it may present an important time for rediscovery for what is starting to become a lost art in stock investing today.

The Dark Decade

No, not the Lost Decade, which relates to Japan in the 1990s and evolved into a Lost Score or Lost Quarter Century depending on how you view what has taken place (and may still be ongoing) since the Nikkei 225 (EWJ) peaked at 38957.44 on December 29, 1989 (it closed at 21181.64 on March 2, 2018, which is down -46% on a nominal basis nearly three decades later - stocks for the really super duper long run?).

Instead, the dark decade I am thinking about today is the one that has yet to come in the U.S. stock market (SPY). Perhaps it will never come to pass, and it doesn't necessarily need to start tomorrow, next month or next year for it to unfold over the course of the next ten years in entirety (ten years, after all, is a long time). And even if a dark decade for stocks were to unfold, it is likely to be far less dramatic or relentless than anything that has taken place in Japan over the years. But if it does indeed come to pass, it is an outcome for which investors should be prepared.

Why the potential for a dark decade ahead? Let's consider the following. Stocks today as measured by the S&P 500 Index are trading at 33.4 times on a 10-year cyclically adjusted price to earnings (CAPE) ratio basis. Maybe you don't believe in the CAPE, as many have worked to refute or dismiss it the higher it climbs. It certainly has little to no use as a market timing tool, never mind that's not what it is really intended for anyway (logically, a market reading based on ten years of history is not best suited for trying to determine what the stock market might do on an intraday basis at any given point in time). Regardless of your view on the CAPE, it still highlights the key point. Stocks are expensive today.

So what? Can't stocks simply become more expensive going forward? Why should this reading matter? Because the valuation of stocks based on the earnings over the ten years that have passed has a good track record in determining the real rate of return, you should expect from the stock market over the subsequent ten years that lie ahead.

The stock market has had 1,525 trading months from January 1881 to January 2008 where both a 10-year CAPE and a 10-year future return can be calculated. Over this 1,525 trading month time horizon, the S&P 500 Index has traded with a CAPE anywhere between 4.78 and 44.20 in any given month. The following is a chart of the 10-year annualized real price return on the S&P 500 Index when the S&P 500 Index is trading with a valuation at or above the various CAPE levels between 4 and 45.

What we see is the following. The lower the CAPE at any given point, the higher the subsequent average 10-year real annualized price returns. But the higher the CAPE becomes at any given point in time, the lower these average future 10-year real annualized price returns become.

Once the CAPE crosses 19, which is only 26% of the time historically going back through history, the average future 10-year real annualized returns start to turn consistently negative. By the time the CAPE reaches 26, which is only 7% of the time over market history, these returns fall more definitively into negative territory on an average annualized real basis over the subsequent ten-year period with each subsequent point higher in the CAPE. Once again, today's market is trading with a CAPE of over 33. How does a more than -3% annualized real return over a ten-year time horizon translate? A more than -30% decline in real portfolio value on average over the subsequent ten-year period historically. Gulp.

For those that dismiss the CAPE, I offer an alternative view. Consider the subsequent average future 10-year real annualized return on the S&P 500 Index for various P/E readings based on trailing 12-month as reported GAAP earnings at any given point in time. For this measure, we have 1,644 months of data from January 1871 to January 2008.

Put simply, once this P/E starts pushing above 20, the average annualized real return on the S&P 500 Index over the subsequent 10-year period turns negative. And the higher the P/E, the more negative these 10-year annualized return figures become.

Where are we today? At 25 times trailing 12-month GAAP earnings having traded as high as over 27 times in recent months. Put simply, the market has historically not performed well on an average real annualized basis over the subsequent ten year period when priced this high. Perhaps the next ten years will be much better than average. Nonetheless, history is not in favor of such an outcome.

So how might we expect the stock market to move lower on an annualized basis over the next decade? Almost certainly not in gradual increments of -1% to -3% per year over the next ten years. That's just not how the U.S. stock market typically behaves. Instead, it is much more likely to come in the form of a barn burner of a bear market (or two) followed by the long, slow slog of working its way back to even. That's how these ten year stretches usually go. Don't believe me? Just look at the most recent example below from 2000 to 2012 with three bonus years included.

In many respects, it has been the stock market over the past decade since the calming of the financial crisis that has been dark. Sure, it has risen steadily and strongly almost without interruption for nearly a decade now. But it has done so without much fundamental support and despite persistent signs of deterioration and rot underneath the surface. For the gains reaped since 2009 have not come as a result of sustained economic growth or robust corporate profit growth.

Instead, stock market gains over the past decade have come despite uneven economic growth, real corporate profits that are no higher today than they were more than a decade ago in 2007, and the persistent threat of the next wave of geopolitical and/or financial market instability lurking at every turn. These gains have come directly as a result of global central bankers pursuing a misguided policy of insisting on trying to create a wealth effect by artificially inflating asset prices in order to achieve economic growth. To date, this policy pursuit has largely failed, yet they are still being pursued in many parts of the globe. And we are now left with record levels of sovereign and corporate debt along with stock markets at premium valuations lacking the underlying fundamentals or growth to support them at current levels sustainably into the future.

Put simply, we are living with a stock market that has been dead behind the eyes and without any normal reflex function for years. After all, bad news is not actually good news but is called bad news for a reason. But the stock market has forgotten this long ago now, and at some point, it will need to undergo the pain of being reacquainted with this idea. In fact, we may even enter a prolonged phase where good news is also bad news. Remember last month's jobs report? Wasn't the sustained rise in inflationary pressures something that investors have been anticipating for years? If the narrative from the financial media was truly correct, the market did not seem to like this "good news" very much. Expect more of this to follow, particularly if global central bankers continue to back away as they are increasingly indicating in 2018.

OK. Suppose we are destined for another dark decade for stocks over the next ten years following the fabulous 2010s. What is an investor to do? Throw in the towel on stock investing? Go to cash and return ten years hence to get back into the markets? Simply despair? C'mon now. We as investors are much better than that.

For in many respects, a period of darkness ahead for stocks over the next decade would represent not lifelessness but instead a return to life. Instead of death, a potential revitalization of investment markets in restoring themselves to what they were in the years prior to the financial crisis and the active intervention by global central banks. In short, an investment renaissance.

The Investment Renaissance

"Return O Zephyr, and with gentle motion
Make pleasant the air and scatter the grasses in waves
And murmuring among the green branches
Make the flowers in the field dance to your sweet sound;
Crown with a garland the heads of Phylla and Chloris
With notes tempered by love and joy,
From mountains and valleys high and deep
And sonorous caves that echo in harmony.
The dawn rises eagerly into the heavens and the sun
Scatters rays of gold, and of the purest silver,
Like embroidery on the cerulean mantle of Thetis.
But I, in abandoned forests, am alone.
The ardour of two beautiful eyes is my torment;
As my Fate wills it, now I weep, now I sing."

- Zefiro Torna (English Translation), Ottavio Rinuccini, Libretto for Claudio Monteverdi, Late 16th Century

The decade ahead need not be one of darkness for stock investors even if measurable losses do come to pass. Instead, it can be a period of renaissance and enlightenment for capital market investors in general. The onset of spring and the return to life if you will of markets that have been rising but otherwise dead for far too long. But it is important to remember - the ceiling of the Sistine Chapel didn't just paint itself overnight. Instead, it required years of hard work. But the end result for all of this hard work was both legendary and highly rewarding.

With this principle of hard work and discipline in mind, just because the stock market has been giving away gains over the past decade just like they did in the 1990s, early 1960s and 1920s don't mean that more gains cannot be had in the subsequent ten-year period.

Now such success is not likely to come from simply throwing all of your money at an S&P 500 Index (VOO) fund and tossing the envelopes of your unopened paper statements in the drawer. For if investment markets were truly to come back to life over the subsequent ten year period, it would mean that the era of index investing that has become once again ubiquitous in recent years would give way to a new era of active management. In short, the easy gains have been had over the past decade. Now it's time to work for it in the next.

To this point, let's revisit the chart above of the S&P 500 Index (IVV) over the period from 2000 to 2012. Put simply, thirteen years of nothing on a price return basis.

But the first important point to emphasize. While the capital gains oriented investor might have been left feeling dark over this time period, the dividend-focused investor (DVY) managed to continue enjoying the steady growth of their payouts over this time period save a brief stretch during the financial crisis. And for those investors that managed their dividend growth portfolios carefully, they primarily owned the names that were able to continue increasing their dividends even during the worst of the financial crisis while many other Aristocrats (SDY) were fading away.

But let's go further than that. For while the last decade has spawned a new generation of dividend growth investors, many have yet to endure the pain of watching the principal value of the portfolio that they worked so hard to accumulate throughout their lives slowly and seemingly evaporate before their eyes trading day after trading day, trading hour after trading hour, for months if not years on end with the still growing dividend payout all along the way providing increasingly less solace with the passage of time. Put simply, many investors, particularly those that have been untested by such past losses, may require more diversification.

The first way to overcome this issue is to move beyond simply indexing your stock strategy and accepting the annualized losses of what may come for the broader market over the future decade and placing a greater emphasis on individual security selection with a focus on quality and value. After all, the stock market is a market of stocks, and while the stock market itself may be falling into a bear market or entering a prolonged phase of back and forth volatility, various individual stocks within the market may be performing consistently well throughout. For example, consider the performance of two high-quality stocks in Southern Company (SO) and General Mills (GIS) during the dark period for stocks from 2000 to 2012. While the stock market went nowhere on a nominal basis with two major drawdowns over this time period, both of these companies generated triple digit cumulative total returns over this same time period. While these companies may not necessarily repeat such outperformance during the next prolonged period of broader stock market indigestion, our market of stocks will have attractive names on offer at any given point in time that should be able to produce such results.

Another way is to begin looking beyond the stock market that has performed so well for so many years to other major asset classes and their various categories and sub-categories. Many investors have the mistaken perception that if they are not invested in stocks, they must be hiding away on the sidelines in cash. But in reality, capital markets offer a variety of opportunities beyond stocks that are largely uncorrelated and provide attractive returns potential in their own right.

Consider the most well-known alternative in bonds. For example, during the dark period in stocks from 2000 to 2012, bonds performed tremendously and consistently well. This included a more than +200% cumulative gain in long-term U.S. Treasuries (TLT) as well as a cumulative +30% gain in ultrashort-term bonds with no measurable drawdowns versus a stock market that lost value on a nominal basis over this same time period.

Perhaps you are someone, however, who is of the view that the nearly four-decade long bond bull market is currently in the process of coming to an end as a result of an outbreak of higher inflation and that interest rates are set to steadily rise (and thus bond prices are set to steadily fall). And while I do not necessarily share this view, it cannot be denied that bond interest rates are also at historical lows and bonds are expensive today in their own right.

In this case, investors may be well served to consider commodities. For even during the period of relative pricing stability from 2000 to 2012, commodities such as copper (JJC) and wheat (NYSEARCA:WEAT) posted robust and strong returns over this same time period. Exactly which commodities might do best during any future period of higher inflation remains to be seen, but such an environment can be highly supportive of higher commodities prices. And as the recent past has demonstrated, the uncorrelated returns provided by commodities can provide their benefits to a broader portfolio even in the absence of sustained pricing pressures.

Perhaps instead you are more concerned about the stability not only of prices but also the global financial system itself. After all, we are now nearly a decade on from global central banks across the developed world relentlessly debauching their currencies in the name of higher risk asset prices and the pursuit of sustained economic growth, the latter of which remains frustratingly elusive. In this instance, allocations to precious metals such as gold (GLD) and silver (SLV) may be worth considering. For while both have struggled in recent years, gold and silver performed exceptionally well during the dark period for the stock market from 2000 to 2012.

Maybe you are of the view that global developed sovereign economies will be able to hold their own through any such future turbulence. Then allocations to selected currencies relative to the U.S. Dollar (UUP) may warrant consideration. Reflecting on the period from 2000 to 2012, both the safe haven Japanese Yen (FXY) and Swiss Franc (FXF) increased in value relative to the U.S. Dollar at a time when the stock market itself was returning virtually nil on a nominal basis.

Or perhaps you are of the view that virtually everything across asset classes may start to come under considerable pressure due to a liquidation event or some other outcome of extreme market turbulence. In this case, alternative hedge strategies that are largely uncorrelated to the performance of the stock market at any given point in time and whose returns are determined by their own unique factors such as managed futures (NYSEARCA:WTMF), equity market neutral (NYSEARCA:QMN), or merger arbitrage (MNA) might be worth considering.

Getting Your Oil Paints Ready

All of this brings us to the bottom line point. Stocks may be facing a dark decade ahead. But this is no reason for despair. Instead, it may bring with it an investment renaissance where many segments of capital markets and their investment strategies will finally have the chance to bloom after an extended period of lifelessness thanks to the extraordinarily aggressive monetary and fiscal policies over the past decade since the outbreak of the financial crisis.

Thus, if any future period of darkness were to befall the U.S. stock market, it would put the end to the current age of indexing and a departure of the near-exclusive focus on the U.S. stock market that has resumed during the artificially inflated years of the post-crisis period. In its place would be the dawn of a new age of active management including the ability for specialized managers to once again add value through their own unique strategies and processes. It would also bring with it a renewed focus on more specialized asset classes that have lately been forgotten in the midst of the ongoing stock market surge.

Nobody ever said that investing in the stock market and taking on risk was supposed to be easy and come without the risk of measurable loss. Investors may soon find themselves becoming reacquainted with such principles as it relates to the U.S. stock market. But with this renewed awareness will also come the enlightenment that hard work and calculated risk taking is once again worth the reward when it comes to investing for the long-term. And such an investment renaissance in and of itself will help to lead to more stable and sustainable capital markets in the long run for us all.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long RSP,SPLV,TLT,PHYS,SO,GIS. 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.