Getting Rich In a Poor Market

Virtually every thoughtful observer of the stock and bond markets has concluded that investment returns in the future are likely to be well below recent returns and even well below long-term norms. This situation is reminiscent of the late 1990s. In 1999, following an almost uninterrupted 17-year bull market, investors on average expected future stock returns to be about 12% per annum. More thoughtful observers were estimating roughly 0%. As it turned out, the answer was 1.95%.

At my own firm, Greycourt, our already low expected returns are in the process of being adjusted downward. Elsewhere, consider Jeremy Grantham. He is, of course, a notorious perma-Bear, but his current market projections are low even by his own pessimistic inclinations (returns on US large company stocks over the next 7 years of -2.1%, for example). JP Morgan, who can usually be counted on to shine the sunniest possible light on the markets, has turned bearish, publishing a piece on future market returns entitled, “Eating At the Minibar.”

Several of the world’s most famous investors have become extremely bearish, exiting the stock markets and buying gold or gold mining stocks. These folks include George Soros and Stan Druckenmiller. Leon Cooperman has spoken of a large bubble in fixed income.
McKinsey & Co., the global consultancy, recently produced a widely read study suggesting that, while stocks have returned about 8% over the past 30 years, investors could expect returns of only 4-5% over the next 20 years. Bond returns, according to McKinsey, would be in the 0% to 1% range. (“Diminishing Returns: Why Investors May Need to Lower Their Expectations.”) No sooner was the ink dry on the McKinsey report than another expert, Lawrence B. Siegel, dissed the report in great detail, insisting that McKinsey had been way too optimistic.

If these experts are right, then the strategies we’ve been following since the Financial Crisis are likely to go a long way toward crushing our returns over the next market cycle – or even a decade or so into the future. So what’s behind all the pessimism? There are many reasons why returns in the future are likely to be lower than they’ve been in the past, but these are the two major ones:

First, concerted and coordinated action by the world’s central bankers has pushed up the prices of risk assets like stocks far beyond any concomitant growth in the world’s underlying economies. They accomplished this via strategies like Quantitative Easing and they did it in an attempt to create the so-called “wealth effect.” In other words, as stock prices rose, people would feel richer and spend more and the economy would grow. Unfortunately, the wealth effect didn’t work because, as I’ve pointed out many times, the only people who own enough stocks to matter are already rich and they don’t adjust their spending depending on whether their stock portfolios are going up or down. Middle income people, whose marginal propensity to consume is much greater, own stocks mainly in long-term vehicles like IRAs and 401(k) plans, so even those folks don’t spend more just because their retirement plans grow.

The disjunction between high equity returns and slow economic growth means that the returns we achieved since the Financial Crisis have been “brought forward.” That is to say that the returns we would ordinarily have received (absent central banker interference) over a ten or fifteen-year period were in fact received over half that time. In order to bring overall returns back in line with GDP growth, future returns have to be much lower.

Second, research has shown (e.g., It’s Different This Time: Eight Centuries of Financial Folly) that the best way to recover from a financial crisis is to adopt pro-growth fiscal policies: tax reform, regulatory reform, entitlement reform, infrastructure improvement, debt reduction, and so on. But the countries of the world didn’t do that. Because political gridlock was the norm in the US, the EU and Japan, governments almost everywhere relied solely on monetary policy to stimulate their economies. This turned out to be extremely unfortunate.

A company or a family doesn’t go out and spend – build a new factory, say, or buy a new house – just because it seems like a good idea. They take those kinds of risks because they are confident in their own futures. A company builds a new plant because it expects demand for its products to grow. A family buys a new house because it expects that its standard of living will go up.

Unfortunately, monetary policy doesn’t inspire that kind of confidence because it is itself a kind of confidence game. Central bankers are in the business of creating the illusion of confidence, but companies and families weren’t fooled. Instead, the more unorthodox Fed policies became, the more alarmed economic actors got. Companies bought back their stock and hoarded cash and didn’t hire. Families battened down the hatches and feared the worst.

Monetary policy so confused the normal incentives that GDP growth never reached escape velocity. We’ve been mired in sub-2% growth for the better part of the decade, by far the worst “recovery” in more than a century. What if this dreary level of growth continues for a decade or more? If it does, we can be sure that market returns will reflect that lower level of GDP activity.

In my next few posts I’ll take a look at the alternatives investors might consider for a world in which they want to get rich but where the markets opportunities are very poor.

Next up: Getting Rich in a Poor Market, Part II