What if I told you that the best you can hope for from stocks over next 10 Yrs is 4.07%/CAGR, before inflation? Does 1.24%/yr over 10 Yr UST Comp You? No

Jeff Bezos has a saying, “Your margin is my opportunity.”  He has found ways to eat the businesses of others by providing the same goods and services at a lower cost.  Now, that makes Amazon more productive and others less productive.  The same is true of other internet-related businesses like Google, Netflix, etc.


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Future Stock Returns

The future return keeps getting lower, as the market goes higher

And, there is a slight net benefit to the economy from the creative destruction.  Old capital gets recycled.  Malls that are no longer so useful serve lower-margin businesses for locals, become homes to mega-churches, other area-intensive human gatherings, or get destroyed, and the valuable land so near many people gets put to alternative uses that are better than the mall, but not as profitable as the mall prior to the internet.

Laborers get released to other work as well.  They may get paid less than they did previously, but the system as a whole is more productive, profits rise, even as wages don’t rise so much.  A decent part of that goes to the pensions of oldsters — after all, who owns most of the stock?  Indirectly, pension plans and accounts own most of it.  As I have sometimes joked, when there are layoffs because institutional investors representing pension plans  are forcing companies to merge, or become more efficient in other ways, it is that the parents are laying off their children, because there are cheaper helpers that do just as well, and the added profits will aid their deservedly lush retirement, with little inheritance for their children.

It is a joke, though seriously intended.  Why I am mentioning it now, is that a hidden assumption of my S&P 500 estimation model is that the return on assets in the economy as a whole is assumed to be constant.  Some will say, “That can’t be true.  Look at all of the new productive businesses that have been created! The return on assets must be increasing.”  For every bit of improvement in the new businesses, some of the old businesses are destroyed.  There is some net gain, but the amount of gain is not that large in aggregate, and these changes have been happening for a long time.  Technological progress creates and destroys.

As such, I don’t think we are in a “New Era.”  Or maybe we are always in a “New Era.”  Either way, the assumption of a constant return on assets over time doesn’t strike me as wrong, though it might seem that way for a decade or two, low or high.

As it is today, the S&P 500 is priced to deliver returns of 3.24%/year not adjusted for inflation over the next ten years.  At 12/31/2017, that figure was 3.48%, as in the graph above.

We are at the 95th percentile of valuations.  Can we go higher?  Yes.  Is it likely?  Yes, but it is not likely to stick.  Someday the S&P 500 will go below 2000.  I don’t know when, but it will.  There are enough imbalances in the world — too many liabilities relative to productivity, that crises will come.  Debt creates its own crises, because people rely on those payments in the short-run, unlike stocks.

There are many saying that “there is no alternative” to owning stocks in this environment — the TINA argument.  I think that they are wrong.  What if I told you that the best you can hope for from stocks over the next 10 years is 4.07%/year, not adjusted for inflation?  Does 1.24%/year over the 10-year Treasury note really give you compensation for the additional risk?  I think not, therefore bonds, low as they may be, are an alternative.

Future Stock Returns

The top line there is a 4.07%/year return, not adjusted for inflation

If you are happy holding onto stocks, knowing that the best scenario from past history would be slightly over 3400 on the S&P 500 in 2028, then why not buy a bond index fund like AGG or LQD that could virtually guarantee something near that outcome?

Is there risk of deflation?  Yes there is.  Indebted economies are very susceptible to deflation risk, because wealthy people with political influence will always prefer an economy that muddles, to higher taxes on them, inflation, or worst of all an internal default.

That is why I am saying don’t assume that the market will go a lot higher.  Indeed, we could hit levels over 4000 on the S&P if we go as nuts as we did in 1999-2000.  But the supposedly impotent Fed of that era raised short-term rates enough to crater the market.  They are in the process of doing that now.  If they follow their “dot plot” to mid-2019 the yield curve will invert.  Something will blow up, the market will retreat, and the next loosening cycle will start, complete with more QE.

Thus I am here to tell you, there is an alternative to stocks.  At present, a broad market index portfolio of bonds will likely outperform the stock market over the next ten years, and with lower risk.  Are you ready to make the switch, or at least, raise your percentage of safe assets?

Article by David J. Merkel, CFA, FSA – The Aleph Blog

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David Merkel

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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