The ETF Strategist: Balancing Risk and Reward for Superior Returns

PART 1

CHALLENGES

Chapter 1

REALISTIC RETURNS

Back in the late 1990s, several surveys of investor sentiment suggested that while investors recognized the possibility of a bubble in stocks, they still held wildly optimistic expectations for their future performance. At the time, it was not unusual for investors to expect 20 percent annual returns in perpetuity. For those investors who were first introduced to stocks in the late 1990s, particularly those invested in large-cap U.S. stocks, this might have seemed a reasonable assumption based on their experience. The reality turned out to be quite different. For investors who entered the stock market in early 2000, much of this decade has proved a bit more difficult. While equity markets have rallied steadily since the bottom in 2002, U.S. large-cap stocks took seven years to eclipse their 2000 peak, leaving investors with only a paltry dividend yield of about 2 percent to sustain them. While some markets have fared better, equity returns have generally been lower this decade than during the previous two. What went wrong? The truth is nothing went wrong, except that many investors had forgotten that bear markets can and do occur, and that no fundamental law of physics guarantees 20 percent annual returns. In fact, some simple laws of economics more or less guarantee that the heady predictions for 20 percent returns were bound to disappoint.

This chapter will focus on what is realistic in financial markets. The argument for starting the book with such a broad theme is that expectations are critical when deciding how to manage your portfolio. Professional investors generally start with a very precise expectation of what their portfolio should return. They even go so far as to put the information on the marketing literature, along with the associated risks. Without specific return goals, any investor lacks context when assembling the different components of a portfolio. In order to generate that context, it is necessary to have some realistic expectation of market returns, which can then form a starting point for your own individual portfolio.

As most individual portfolios comprise mainly equities, this chapter focuses on what to expect from equity markets over the long term. If you know at the outset that world equity markets have generally provided a total return of around 7 percent to 10 percent, those expectations form an anchor in assessing your own financial goals. You may do a bit better than that average through careful management and a more aggressive stance, or a bit worse if you’re defensive, but at least you have some feel for what’s possible. Unfortunately, for most investors who have come of age over the past twenty years, a realistic sense of the long-term possibilities of equities is lacking. That is because the period from 1982 to 2000 was anything but typical. This chapter examines that period in an attempt to establish a more reasonable starting point for establishing realistic financial expectations.

The one defining characteristic of market bubbles is that they are obvious after the fact, but hard to identify while they’re going on. Like most bubbles, the early impetus for the bull market began with significant improvements in the real economy. Beginning in the early 1980s, inflation and interest rates started to fall. By the 1990s, U.S. productivity had accelerated to its highest level in decades, and corporations were making unprecedented profits. However, by the late 1990s many world equity markets had become the embodiment of a classic speculative bubble, in which stock prices became completely unhinged from their underlying fundamentals. Wall Street legend has it that Joseph Kennedy knew it was time to get out of the stock market when the shoe shine boy began to give him stock advice. My own version of that story occurred in late 1999. One night I walked across the street to buy a Twinkie from the local small grocer. Unfortunately, the Twinkies were unavailable because the deliveryman who was supposed to be restocking the Hostess display was too busy trading options with his broker on his cell phone. I remember thinking that this was not a good sign. Sky-high price-to-earnings ratios, speculative message boards, and 300 percent gains on recent IPOs were one thing. Not being able to buy a Twinkie in the heart of New York because the deliveryman was trying to shave a sixteenth of a point on his Pets.com trade was, for me, the definition of a speculative bubble.

Investors today need to face the challenges of investing without the more-or-less consistent tailwind they enjoyed in the period between 1982 and 2000 (I say more or less as there were two bear markets in that period, in 1987 and 1990, both unusually brief). The 1980s and 1990s were a distinctly prosperous time for most investors. If you were invested in equity or bond markets during those decades, you could not help making money. From 1982 through 2000, financial markets enjoyed a once-in-a-generation period of stellar returns. The euphoria, of course, reached a crescendo in the final five years of the century, when market gains reached a magnitude and consistency rivaled only by the period leading up to the 1929 stock market crash.

It’s critical for today’s investors to understand how large those gains were in relation to normal market conditions. Of equal importance is quantifying why the conditions that led to those gains are unlikely to repeat themselves anytime in the near future. Start with a simple quantification of market gains based on the most popular index of large-cap U.S. equities, the S&P 500. Looking back over the last eighty years, monthly gains on the S&P 500 have averaged roughly 0.80 percent per month, excluding dividends (we will return to the dividend issue a bit later). Obviously, there has been a good amount of volatility around that average, but over the long term it has been consistent for the better part of eight decades. While stock markets can diverge from the fundamentals for long periods of time, ultimately the value of any security, and therefore the market in aggregate, is anchored by real economic activity. As economic growth is limited by its inputs, which include labor, capital, and productivity, there are natural limits on how fast economies can grow, which should exert some limits, at least over the long term, on financial assets.

NORMAL IN THE 1990s

Despite this long-term speed limit, markets can and do grow faster than economies, often for considerable periods. This is exactly what had happened by the later part of the last decade. By the time the millennial celebrations were in full swing, the S&P 500 had averaged gains of 2 percent a month for sixty consecutive months, or five

Chart 1: S&P 500 Monthly Price Return (60-Month Average)

years. In other words, large-cap U.S. equities were appreciating at two and a half times their long-term average, and had been keeping up that pace for half a decade. The only other time in recent memory when this had occurred was in the summer of 1987. Prior to 1987, you need to go all the way back to the late 1920s to find a period when stocks gained that much for that long. So during the nearly two decades between the early 1980s and 2000, investors in U.S. stocks enjoyed not one but two separate five-year stretches when simply buying and holding an index of large-cap U.S. stocks produced gains in excess of 25 percent per year—an environment that had not existed for two generations of investors prior to those periods.

Now some could argue fairly that the gains on the S&P 500 were not representative of the overall market, as the late 1990s were dominated by a fetish for large-cap stocks, and that other segments of the market did not enjoy similar gains. There is some truth to this. Using the same methodology on the Russell 2000, an index of two thousand smaller U.S. companies, suggests smaller gains over the same period. While the advance in the Russell 2000 was significantly

Chart 2: Russell 2000 Monthly Price Return (60-Month Average)

above average, it was not nearly as pronounced as in the large-cap universe. Indeed, one of the anomalies of the end of the 1990s bull market was how concentrated the gains were. By 1999, a disproportionate amount of the 25 percent annual gains were concentrated in a handful of large-cap equities, particularly technology stocks.

The counterpoint to the underperformance of small-cap stocks is the extent to which some market segments appreciated at an even more dizzying pace. While U.S. large-caps were gaining at roughly 2 percent a month, some sectors of that market were doing even better, in some cases much better. The price of technology shares, in particular, rose in a manner defying any economic or fundamental logic. The bubble in NASDAQ stocks has been well documented, yet given the sheer magnitude of the run-up in technology shares it is worth reiterating. The five-year average monthly gain for the NASDAQ Composite had reached an unprecedented 3 percent by the conclusion of 1999. By the late 1990s the relationship between technology stocks and their underlying fundamentals had become completely unhinged.

Chart 3: NASDAQ Composite Monthly Price Return (60-Month Average)

To put things in perspective, a 3 percent average monthly gain translates into a compound return of roughly 100 percent every two years. If this were a particular stock, and its price-to-earnings multiple (P/E) were to remain constant, this would indicate that the company’s earnings would need to grow 100 percent in just two years. Now while there have been individual companies that have accomplished this feat, it is a rarity. However, the 3 percent returns described above are not for a particular stock, but for an entire market, comprising thousands of stocks. So in effect, investors who were bidding up NASDAQ stocks in the late 1990s either were making some outsized assumptions about earnings growth or were convinced that the greater fool theory would ensure that there was always another marginal buyer who would take the shares off their hands. Returns of that rate are rare, and often unjustified in individual stocks, but are the stuff of legend for an entire market index, particularly one in a developed country.

And while financial crises such as the Asian contagion of 1997 and the Russian default of 1998 resulted in significant dislocations in many foreign markets, international equities still managed to put on an impressive show during the concluding years of the 1990s. The MSCI World Index appreciated by nearly 1.5 percent a month, on average, during the period from 1995 to 2000. So while magnitudes did differ, and international securities and U.S. small-cap names trailed U.S. large-cap and technology shares, virtually all equity markets luxuriated in a prolonged period of coordinated growth. This period was defined by gains that were significantly above their long-term averages and persisted for many years. In short, the period that witnessed the rise of the U.S. retail investor was in no way indicative of normal market conditions. Instead, it was a once-in-a-generation confluence of good fundamentals and giddy speculation.

THE DEBT THAT EQUITY INVESTORS OWED TO THE BOND MARKET

Some pundits have argued that there is no physical law to prevent the good times from continuing. As of this writing, the world economy is robust, interest rates and inflation remain low, and financial liquidity is more than ample. With some justification, they can point to a four-plus-year bull market, already one of the longest on record. Indeed, the optimists list a host of reasons to support another prolonged bull market and the potential for similar gains in the near term, including: the fall of communism and a more inclusive world labor market, the accelerating pace of technological innovation, a more stable business cycle, and in some ways, a more stable geopolitical environment.

While all of these factors should theoretically reduce risk and potentially raise earnings, they are still unlikely to lead to the same type of appreciation witnessed in the 1980s and 1990s. There are two reasons for this. First, stocks were considerably cheaper at the start of the 1982 bull market than they have been at any time since. In other words, when the bull market began twenty-five years ago, stocks were trading at bargain basement prices. Second, not only did earnings surge in the 1980s and 1990s, but so did valuations. Much of the rise in valuations, or earnings multiples, can be attributed to a onetime secular, or long-term, decline in inflation. Having already occurred, a similar drop in inflation cannot provide a second tailwind for stocks. In fact, with inflation already in the 2 percent to 3 percent range, any meaningful drop in inflation from current levels would be indicative of deflation, not necessarily a plus for equity investors.

The first argument against another 1982 - 2000 bull market is the price of shares today versus their level in 1982. Twenty-five years ago, at the start of the last bull market, you could buy the S&P 500 index for just eight times earnings. In other words, investors were only willing to pay eight times the previous year’s earnings for large-cap U.S. stocks. In contrast, at the peak of the bubble, that measure of value had expanded to more than thirty, a quadrupling of valuations. So in 2000, investors were willing to pay four times more for a given stream of earnings than they were eighteen years