- The current stock market will, on average, deliver returns of 4% per year for the next 15 years. However, the risks don’t justify the returns.
- All investors owning an S&P 500 or similar portfolio should know that they run the risk of a 50% temporary decline.
- Various sectors and countries offer much higher returns for the same inherent volatility.
What’s equally important to how much you expect to make from your investments if things go well is the question of how much volatility you can take if things go wrong. Today’s article is more of a reminder that there are two sides to each investment, the return side and the risk side.
I’ll elaborate on techniques that will help you assess your future returns and risks. We’ll start with the fun part, the returns, and finish with the necessary part, the risks.
What Will Your Future Returns Be?
Nobody knows for sure where the market will go in the short term but in the long term, it can be predicted with a decent amount of precision. Stock returns are correlated to business performance and earnings which are correlated to economic performance. What many forget, especially after 7 years of economic expansion, is that the economy works in cycles where expansion periods last a while but are inevitably interrupted by recessions.
The Cyclically Adjusted Price Earnings (CAPE) ratio is a great tool to see how a business or portfolio will perform in the long term as the CAPE uses 10 year averages for earnings in order to eliminate cyclical influences. Every business does well in an expansion, what’s important to know is how it will fare in a complete cycle, thus also during a recession.
History is pretty precise on what market returns will look like as long term returns are decently explained by the CAPE ratio. The current S&P 500 CAPE ratio is 28.91. According to history, you can expect returns of a maximum 4% per year in the next 15 years from stocks.
Figure 1: CAPE ratio on Japanese, German and U.S. stock markets. Source: Star Capital.
If you own a portfolio with a lower CAPE ratio, perhaps a more international portfolio, you can expect higher returns but if you own a portfolio similar to the S&P 500, you can expect returns around 4% per year. I find 4% per year a miserable return for the risks people invested in the S&P 500 run.
How Low Will The Market Go?
First, let me show you what has happened historically when the CAPE ratio has been relatively high.
Figure 2: S&P 500 and past overvalued periods. Source: Star Capital.
There have been six times in history when the CAPE ratio exceeded 24, 1903, 1929, 1970, 2000, 2007, and now. Four out of the five past cases have seen the S&P 500 go nowhere for the next 15 years (don’t yet know for 2007).
In addition to going nowhere for 15 years (blue line), each high CAPE period precipitated an extreme bear market. From 1929 to 1932, stocks lost almost 80%. In 1974, stocks lost 42%. In the 2000s, stocks lost 45%, while in 2009, stocks lost 48%.
All investors owning an S&P 500 or similar portfolio should know that they run the risk of a 50% temporary decline for a 4% average yearly return for the next 15 years. The positive is that the 50% decline will be only temporary so it isn’t a risk of permanent loss, but it still isn’t nice to look at.
What Can You Do?
What to do is pretty simple. Look for good businesses with low cape ratios.
2016 gave plenty of opportunities to do so with a slump in metal and oil prices at the beginning of 2016, slump in food prices in the middle of 2016, and the slump in pharma and gold prices towards the end of 2016. With patience and by following Investiv Daily, the market will offer you plenty of opportunities to find cheaper companies that are going to give you higher long-term returns.
Another option is to look at cheaper companies on a global level.
Figure 3: The U.S., Ireland and Denmark have the highest global CAPE ratios. Source: Star Capital.
Countries like Brazil, India, China, Israel, South Korea, Turkey, and Italy hide extremely interesting long-term investing gems.
How Can You Protect Yourself From Potential Temporary Downside?
This one is difficult. In a bear market, the above described emerging and global markets get hit hard as investors flee to assumed safety back to the U.S. Therefore, the inherent volatility is something that can hardly be mitigated. But, what you can do, is chose investment options that will give you much higher upsides before and after a bear market comes along.
Further, having a part of your portfolio in cash will give you firepower when it’s most effective, in a bear market, and will limit your downside. Deploying cash when stocks are cheap will largely increase your returns. Fortunately, the opportunity cost of holding cash isn’t high as stocks are expected to return just 4% in the long term.
With global assets inflated by quantitative easing policies and the market driven by passive investors, I can’t say that a sector like the usually defensive consumer staples can offer more protection in a bear market. Therefore, cash remains the best option.