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If Future 5-year Returns is Low, then How do we Invest?

Many readers have gotten really good value from yesterday’s slide deck by JP Morgan.

But the aspect that leaves investors concerned was the 5-year subsequent stock market performance after we have a rather high price-earnings read.

Some have asked how I would invest in this climate, and the truth is, 21.5 times PE is above average but you can see that in some instances, subsequent 1-year returns can be 20%.

Usually, low 5-year annualized returns mean that somewhere in the next 5 years, you are going to get a nasty one where it takes the returns down to 0% a year or slightly below that.

I have seen enough of these data at work. It can get rather demoralizing.

The danger for those who are perhaps less sophisticated is that they treat this as a be-all-end-all.

We can always frame things differently.

  1. While we do not know which factor premiums will show up, we know that the market-risk premium tends to be more consistent and pervasive. The market risk premium is the premium you earn by taking risks, investing in risk assets such as equity over risk-free bonds.
  2. If you have not accumulated your wealth, you got no choice but to take risks in a sensible way, that will give you a high probability of earning better than average returns.
  3. Returns could be lower in this sequence, but over the long run, it should still have a high probability of working out.
  4. Investing in risk assets (property, equity, bonds) is unknown. Past data is used as a guide and we hope things continue. We do have a lot of data of past economic regimes, changes in margins, PE, earnings per share, bear markets, bull markets, technology boom, value doing well, growth doing well, semi-conductors doing well, semi-conductors doing badly to help us form our opinion.
  5. Annualized 5-year 0% return is not really bad news. It means you put in $1 million and end up after 5 years with $1 million. It is not $1 million you end up with $500,000 after 5 years.
  6. If the market goes through an environment where your rate of return for five years is 0%, it provides a low price-earnings, depressing environment. That could be the best environment for an accumulator because you should be glad there are more of these environments where prices are more attractively priced.
  7. The person with 5 years to retirement will also be in a relatively good situation because you are still working, you are still accumulating, you leave that 5 year period and emerge at a time where your sequence of return is great. So instead of a rather conservative 3-3.5% initial withdrawal rate, you may be able to start with a more optimistic 4% initial withdrawal rate.

Data and investing is just one aspect of the equation. Financial planning is another aspect.

And that includes your unique life situation.

How Price-Earnings can Improve Positively

The other thing is that the situation may not be so bad.

Market prices to me is a rough aggregation of = dividend yield + earnings growth + price-earnings expansion + crowd psychology + funds flow.

We will leave crowd psychology and funds flow aside.

It may be hard for us to visualize this interplay but I found a Fidelity technical analyst Jurrien Timmer who has a great visualization of how this interplay works out for the past 18 years.

Click to see a larger visualization

This chart shows the changes in earnings growth, price-earnings from 2004 to 2021 start.

COVID-19 and GFC may have some similarities in that prices got depressed to a large degree. Earnings tend to lag the changes in prices. This means that earnings are slower than market prices to reflect the fall and subsequent rises.

If things played out the way they should, we should be seeing some EPS growth over the next two years. JPM uses a forward price-earnings so that baked in the expectation that earnings will improve going forward.

The question is how long is the earnings improvement will last. If it lasts longer than the share price increase, we improve the price-earnings.

The bull market for the past decade is built on the price-earnings expansion (look at the blue bars). That is not the most healthy stuff and we can go into a long debate on whether earnings is the best measure of things going forward.

Ultimately, we may be in a year-2 of a secular bull market. And usually, year 2 of the bull markets are rather rough. It’s not like you gonna see a big plunge, but you get volatility and most of us don’t take to this well.

Another thing to note from the chart is the part from 2004 to 2007.

That is the period where most of us long-timers know no one wants to invest in the USA and wishes to be in emerging markets.

Price-earnings contract. Earnings-per-share grew.

I think that the lost-decade in S&P 500 sets up for the next decade.

Will think reverse?

Maybe. The worse thing for the S&P 500 is a PE contraction. That could work out.

But the music might keep playing.

There is another thing about flow that I have not talked about. But for that maybe another day.

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Monday 5th of July 2021

Oh forgot about the "flows before pros" zeitgeist that's floating around the markets.

People are now comparing the present with major demographics generational replacement, where a large cohort enters into their peak earning & spending years.

In the 1950s & 60s, it was the "Greatest" generation (the large generation born during the Roaring 20s & fought in WW2). Like you've said, many large cap & tech stocks in the US got very very expensive by the late-1960s Nifty Fifty period.

In the 1980s & 90s, it was another large cohort, the Boomer generation (born during 1945-65), culminating in the dotcom boom.

In between, during the 1970s and 2000s, these period were dominated by the Silent generation (born during 1930s Great Depression & WW2) and Gen X (born during 1970s & early 1980s stagflation & bad economy). Both these 2 generations are smaller in numbers, and if you give a lot of weight to demographics, hence the speculation that the number of peak earners during 1970s & 2000s weren't enough to boost the economy or stock market.

People are now saying that the 2010s & 2020s is the turn for the large cohort of Millennials to come into their peak earning years, buying houses & forming families, and investing for their future retirement. This is another large cohort, born during the boom times of the late 1980s & 1990s.

So if you buy into this demographics theory, we're already halfway into the secular bull. During such secular bulls, any crash or bear market is either shallow, or will have fast recovery e.g. the mild recessions in the 1950s, 1987 crash, 1990 bear, and 2020 Covid.

PS: Gen Z (those born during the recession-packed 2000s) is a smaller cohort, so theoretically the 2030s will be bad for stocks & economy.

PPS: Kondratiev wave or supercycle theory also use demographics as part of the explanation.


Thursday 8th of July 2021

Yes, I also think the next Big One is going to be like another -60% or greater hit.

But whether it happens in 2 years or 5 years is the 64 trillion dollar question.


Thursday 8th of July 2021

Hi Sinke, thanks for sharing your thoughts. I read a little about the generational getting into their peak earnings years one. Seems like we can find correlation everywhere. I do think that in this market, we are likely to get sharper and greater correction then last time, due to how much liquidity there are in the markets.


Monday 5th of July 2021

Same message from people like Ray Dalio & Jeremy Grantham.

Here's another chart of CAPE and the subsequent 10-yr returns of S&P 500 from Deutsche Bank.

Whether we get a 1987 crash followed by relatively quick recovery or a long-drawn 2000-2003 bear market in the next 7-10 years is anybody's guess.

But probably in the short-term of 6-to-18 months, we are likely to see a big meltup in stocks.

For people who have no inclination & no time to follow markets & navigate in real time, then best approach is still to be truly diversified across sectors, asset classes (including cash & short-term govt bonds), countries etc.

You give up on extraordinary returns, but trouble often comes when people want to have very good returns without being willing to take responsibility & accept sacrifices, including large losses or drawdowns -- which is a sure thing.

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