This Time is... Dangerously Different

Stock and bond investors face a challenging market outlook over the next decade. You can't just use last decade's playbook.

It is often said that the most dangerous four words in investing are "this time is different."

Typically, after these words we're pitched on some new-fangled speculative opportunity. Instead, here's an old-fashioned warning: we believe markets are overly complacent due (as usual) to an exceptionally buoyant past decade.

Side-stepping the myopic rush of the moment is always hard. Market bubbles remain a major risk to wealth growth, and we appear to remain in one today – whether investors acknowledge it or not. We observe annual "capital market assumptions" from leading firms remain rosy, and that when investors face divergent views, it's tempting to fall back on those most similar to history or each other. This can cloud judgment. Any true financial plan must build from objective, research based market projections.

Finding True North

Altar Rock is an independent advisory firm where research based projections form the bedrock of our advice. The partners here have a long history of econometric research into markets and economies. While anti-myopic overall, we seek to understand the big picture by studying important details. We embrace probability and recognize that, while individual months or quarters may surprise, longer-term patterns often emerge. We then apply the outlook consistently to plan budgets, pick investments, and rebalance portfolios.

What are We Most Worried About?

Consider today's outlook relative to a more normal one, and in particular, relative to that which applied a decade ago. In a "normal" decade, by our estimate, equities return nearly 8% annually, providing growth to overcome inflation and taxes. But today's prospects are less sanguine:

We project that over the coming decade investments in US large-cap stocks may compound at a median 5.1% (middle value of projected range), or 2.7% lower than in equilibrium. This is well under half their actual growth rate of the past decade – consistent with how much today's setting has changed from 2013. A 2+ point haircut from normal expectations is painful to imagine; a 7+ point shortfall from the past decade even more so. Planners, take note.

We project that intermediate-term US treasuries will compound at a median 4.1%, also lower than normal times, albeit a multiple of recent experience. Most notably perhaps, the difference between our projected medians – often denoted the equity risk premium – is a paltry 0.9%. This alone calls into question many rules-of-thumb for allocation and sustainable spending.

To be emphatic: this is among the dourest outlooks we have formed in our professional lives

Lets unpack our approach, then look deeper at current conditions and projections, and finally consider implications.

Our Approach

Market returns are of course unpredictable – any forecast for equities over the coming year must allow bands of, say, +/- 18% for volatility surprises. The equivalent range for bonds may be roughly +/- 8%. Yet over longer horizons, as economic, business, and monetary policy cycles play out, extreme price or yield moves in either direction can tend to reverse. Conversely, creeping trends matter: poor earnings in a given year may not impair management's dividend policy, but multiple bad years can. So with inflation: most of us can withstand a transitory price shock, but as an uptrend develops, cost-of-living adjustments to wages may become self-reinforcing. In short, the temporal logic of markets helps form reasonable estimates of ranges or bands within which compounding rates are probabilistically likely to land.

A thorough approach in our view should incorporate starting yields, valuation ratios, the state of the business cycle, and causal or statistical linkages among these. It's important to proceed with rigor, discipline, and humility. Looking across leading firms' published assumptions, we find surprising departures from internal consistency, including ambiguity around timeframes or even between arithmetic and geometric averages.

Done right, projections should make logical sense across assets and along paths. Projections should cover all relevant asset subclasses, including private equity, private credit, and real estate. Of course, models for such private investments should draw from those of their closest public market counterparts, while adding considerations for illiquidity, vintage, pace, control premia, and other unique aspects.

Where we stand today

The US economy remains just shy of a confirmed recession. S&P 500 stocks are up +16.9% thru midyear, nearly reversing their 2022 decline, hence continuing the post-GFC bull run. The recent increase is concentrated in top-10 mega-cap tech names, while most stocks remain roughly flat. The stock index is expensive today at around 25 times trailing earnings, or 19 times forecast earnings. The manufacturing bullwhip recently contracted; office real estate remains in a funk.

Yet hopeful stories are circulating: the Artificial Intelligence revolution has arrived; home prices and consumer sentiment picked up; inflation moderated and wage pressures remain in check. Banks and households remain well capitalized. While the Federal Reserve Board tightened too late, they now have ample room to ease. It is tempting to wonder whether we might still achieve a soft landing – or even a liftoff.

When so many complex factors are in flux, a calibrated econometric framework can provide clearer indications than intuition alone can.

A Closer Look at Our Projections

Two topics deserve particular mention today: inflation and short rates.

Inflation was quiet post-Volcker thru 2021, then jumped. At right we depict the range of our projections 5- and 10-years ahead: the projected median lies where the colors meet; boxes extend to 25th and 75th percentile values; whiskers extend further to 5th and 95th percentiles.

While our inflation projections do not support a quick reversion to the Fed's stated 2% target – which market consensus and Economist Intelligence Unit still expect – three-quarters of the projected ranges lie below today's starting level. So we can reasonably expect inflation over the next cycle to lie within the newly tolerant range ("2 percent plus") toward which the FOMC has gestured.

Turning now to the opportunity in short-term bonds, or 3-month Treasury bill yields (aka Cash), projections confirm that we are near the rate peak for this cycle:

But current levels may not disappear in a hurry. With a 5-year median projection of 3.3%, the attraction of "cash" or short-term bonds remains higher than has been the case in over 15 years. So the appeal of cash-like investments, particularly in a world with higher geopolitical risk and market volatility, will remain strong. This also means that our long-inverted yield curve could soon begin to normalize.

Potential implications

Nothing here indicates a wholesale rejection of stocks. But going forward, unlike the past decade, one can't simply lean into stock portfolios and ride the equity risk premium. Moreover as 2022 showed, sometimes stocks and bonds disappoint. So investors need to consider structural means to navigate lower returns, persistent inflation, and volatile markets. They should reassess fee slippage to keep only the highest conviction active managers – or their lowest-fee passive counterparts. They should avoid tax slippage – whether from income, realized gains, gifts or estates. Most of all, advisors (and planners) should revisit spending budgets and the feasibility of wealth transfer goals and philanthropic aspirations.?

Need we add attractive investment opportunities will inevitably come along; to find them however, investors must think differently and work harder. As usual every investment decision should be made in the context of a client's unique circumstances, goals, timeframes and risk budget.?

We believe investors and their advisors need to refocus to ensure that portfolios are ready for the more meager returns of broad, liquid asset classes that we project may lie ahead.

THIS POST IS SOLELY FOR INFORMATIONAL PURPOSES AND IS NOT INTENDED AS INVESTMENT, TAX OR LEGAL ADVICE. ALSO NOTE THERE ARE NO SPECIFIC BUY OR SELL RECOMMENDATIONS HEREIN. STATEMENTS, OPINIONS AND OUTLOOKS ARE SUBJECT TO CHANGE WITHOUT NOTICE. ADVISORY SERVICES ARE ONLY OFFERED TO CLIENTS OR PROSPECTIVE CLIENTS WHERE ALTAR ROCK IS PROPERLY LICENSED.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RETURNS. INVESTING INVOLVES RISK AND POTENTIAL LOSS OF CAPITAL.

FORWARD LOOKING PROJECTIONS ARE PRODUCED BY PROPRIETARY RESEARCH. WHILE THESE ARE DEVELOPED WITH CARE, THERE CAN BE NO GUARANTEE OF DEPICTING THE FULL RANGE OF POTENTIAL FUTURE RETURNS OR OF MATCHING THE TRUE, UNKNOWN PROBABILITIES OF OUTCOMES.

ILLUSTRATIONS USE PROJECTED RETURNS FOR U.S. LARGE-CAP STOCKS AND 7-YEAR U.S. TREASURY BONDS AS MODELED BY ALTAR ROCK. THESE SHOULD NOT BE VIEWED AS REPRESENTATIVE OF OTHER ASSET CLASSES, MIXES THEREOF, OR ACTUAL INVESTMENT PORTFOLIOS THAT MAY EMPLOY STRATEGIES NOT DEPICTED HERE. INDICES ARE TYPICALLY NOT AVAILABLE FOR DIRECT INVESTMENT, ARE UNMANAGED AND DO NOT REFLECT FEES OR EXPENSES.

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