“Between the optimist and the pessimist, the difference is droll. The optimist sees the doughnut; the pessimist the hole!” – Oscar Wilde.
2020… What a year it was! Now that it finally is behind us, the question of what to expect of 2021 grows ever more pressing. As we digest Q1 2021 market outlooks and read through last year’s summary and analysis, we are impressed by how contrasting pundit’s predictions are. Nonetheless, it comes as no surprise given how polarised 2020 was. In 2020:
Those readers wondering why the above has a US-focus may understand that it is because the US has the dominant share slice in the global economy (+/23%) and its stock exchanges account for circa 47% of global market capitalisation. Therefore, what happens in the US affects, and is affected by, what happens in the rest of the world.
Now for the exciting part… How about 2021? As we have written in a previous article, we find that the best way to predict the future is to have a solid understanding of the past. History doesn’t necessarily repeat itself, but it often rhymes. Historically, what can we (reasonably) expect of 2021?
Going back 119 years from 1901 to 2019the American stock market has registered the following annual dispersion of returns:
1. 51% of the time between -16% and + 16%
2. 34% of the time more than 16%
3. 14% of the time less than -16%
You read that correctly. If you are investing for the long term, be prepared to see your allocation to stocks fluctuate inside a 32% range most of the time, and to see your shares drop by more than 16% once every 8.5 years. Scary numbers, indeed. Is it worth it?
In the graphs below, courtesy of Crestmont Research, we can see the average 10-year return one would have had by investing in the S&P500 at the start of each year. TI.e: the last bar on the left graph (2019), shows that if you had invested during the 10 years ending in 2019 (2009-2019), you would have had an average return of 14.423%. In other words, a $100,000 investment would have grown to $435,524.2 if compounded.
The left-hand graph also shows that this was a phenomenal, and above-average, return. Most 10-year periods were not as sympathetic to investors. We find both charts to be quite insightful when read together.
Now that the reader already has a more informed feel of the risk, and potential rewards, of investing in stocks over long periods, what is it reasonable to expect? Pundits often cite the 10% annual average return but does average ever happen? Can a conservative financial advisor use that figure as a base assumption of future returns when deciding how much his/her client can afford in retirement, or how much does he/she need to save to retire comfortably? Our opinion: not really.
In the right graph, we can see that annual returns are rarely around the average. On 43% of the time, the yearly return is lower than 8%, and as mentioned earlier in this article, it is lower than -16% once every 8.5 years.
Returning to a long-term approach, we now focus on compound average returns over 20-year periods. The outcome of the graph above is very similar to the earlier chart: the blue bars show the average compound return for 20 years ending in a specific year. That is, if you had invested during the 20 years ending in 2019 (1999-2019), you would have had an average return of 6.08%. In other words, a $100,000 investment would have grown to $339,056.68 if compounded.
On the same graph, the red line represents the expansion and contraction of the Cyclically adjusted price-to-earnings ratio, as introduced by Robert J. Shiller. We can immediately draw a critical conclusion: when the Cyclically adjusted price-to-earnings ratio (red line) is rising, 20-year returns (blue bars) tend to be above-average. The opposite also holds. In a future article, we will expand on why this phenomenon occurs. Still, for now, the reader only needs to know that most of the stock market’s volatility is driven by investors’ risk appetite/aversion and that economic developments account for the rest.
Now that we have established this pattern of how rising price-to-earnings ratios lead to above-average returns, we need to understand 1) what is the current price-to-earnings ratio, 2) is it likely to go up, and 3) is it likely to go down?
Source: Bloomberg Data, Abacus Wealth Management
At the time of writing, the S&P500’s Cyclically Adjusted PE Ratio is registering its second-highest value in history (34.19), which places us well within the 1st Decile of 20-year future returns – with a below-average 5.1% annual return in the next twenty years to come.
You might be thinking this is too complicated for you to handle by yourself… We have good news: you do not need to. By working with an Abacus Wealth Management advisor, you benefit from having our knowledge, expertise and technical software available for your benefit. Contact us or book an appointment via our website. I, if you are unsure how you can position yourself to take advantage of this confusing market-environment, or simply wish to protect yourself, and your family, against nefarious market movements, we hope to hear from you soon.
By Joao Feliciano Martins,
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