The Only Way To Beat The Market In The Next 10 Years

January 26, 2017

The Only Way To Beat The Market In The Next 10 Years

  • Investment performance has to be assessed through a complete economic cycle in order to reach the highest possible long term value.
  • In this century, stocks have performed poorly from peak economic cycle to peak economic cycle.
  • Analyzing fundamental risk against the recent performance of the S&P 500 shows us that those who are long the S&P are practically accepting long term negative returns for momentum created short term positive returns.

Introduction

Recently, we analyzed Seth Klarman’s amazing performance and investing rationale. There were some pretty difficult things to digest, like the fact that he underperformed the S&P 500 by 50% in the late 1990s.

But this leads us to some very interesting questions: Do we properly measure investment success? Is the investment manager that invested in internet stocks in the period from 1996 to 1999 a good manager? Similarly, is the manager that created wonderful returns in the last 7 years by being long U.S. stocks a good manager?

If we look at the returns achieved in those periods, the answer is a clear yes. However, there are other factors that are usually completely disregarded by investors.

Two additional pillars for measuring investment success are economic cycles and fundamental risk. Today, I’ll elaborate on how to include these concepts in your performance assessment in order to reach higher returns with lower risks and the highest possible long term value from investing.

Economic Cycles & Investment Returns

One of the most common pitches for equities is describing them as the best asset to own because historically they have outperformed all other assets. The statement in the pitch is true, but sometimes it may take stocks a few decades to beat other investment vehicles while sometimes stocks are simply too cheap and perform amazingly. Therefore, when looking at investment returns, it’s of extreme importance to measure them through a complete economic cycle as it’s the only way to assess the real value creation a strategy or an asset manager brings.

Looking at performance in the short-term—that is, in periods shorter than 10 years—doesn’t eliminate the factor of luck. New investment vehicles are created daily, and the ones that create immediate success attract more customers which further fuels the upside. The funds that perform poorly are quickly closed as customers run away.

This is exactly what’s affecting the current market. Passively managed funds have outperformed actively managed funds in the last 7 years, and funds continue to flow into passive investments only because of their recent performance.

The flow from active to passive is staggering, the figure below shows the situation in the last few years.


Figure 1: Funds flow into passively managed investment vehicles. Source: Bloomberg.

Just because passive has outperformed active doesn’t mean it will continue to do so in the future or that no active managers will be able to beat the market. This really shows us how few people look at investment returns from a longer-term perspective.

Stocks in general, passively managed, haven’t performed that well if we assess their performance through the last two economic cycles from peak to peak. If you had invested $100,000 in stocks, treasury bills, and treasury bonds in 2000, the winner would have been bonds. Treasury bills also outperformed stocks up until 2012.


Figure 2: $100,000 in stocks, bonds, treasury bills. Source: Stern.NYU.edu, compiled by author.

$100,000 invested in stocks would have returned $209,746.30 by the end of 2016, while the same amount invested in U.S. treasury bonds would have returned $244,110.86 and you would have avoided the two extremely painful bear markets in the periods from 2000 to 2002, and 2007 to March 2009.

From the peak in January 2000, the S&P 500’s yearly return is only 2.5%, and from the 2007 peak, it’s a bit better but still only 4.2%. Therefore, if you are a long-term investor and you want to assess performance, you should really look at how a fund performed in a longer time frame that includes a few economic cycles.

Apart from taking a longer-term perspective on performance, the second factor that is extremely important for the measurement of investment success is fundamental risk.

Fundamental Risk & Investment Returns

If you have a 10-year or longer investment horizon, then stocks are the place to be, but there is a catch.

Digging deeper, there are many different stocks and stocks will perform differently over time. One factor that has proven a good indicator of long term returns are fundamentals. The figure below shows the relation between the price earnings ratio and S&P 500 return.


Figure 3: Starting PE vs. ensuing 10-year returns (R2 = 0.8945). Source: FactSet.

The lower the PE ratio, the higher the future S&P 500 annualized returns are because in the long-term, stocks reflect the performance of underlying fundamentals.

The current S&P 500 PE ratio is 25.43. Circled in the figure above are the 10-year market returns achieved when market PE ratios were above 24.

Unfortunately, I have to tell readers who are long the S&P 500 that 10-year returns in the past have only been negative at these valuations. Therefore, you should lower the average PE ratio of your portfolio in order to reach better returns, you can find some low PE long-term stock picks here.


Figure 4: S&P 500 historical PE ratio. Source: Multpl.

Conclusion

I had two goals with this article.

One is that the positive performance of S&P 500 related investment funds has to be taken with a grain of salt because we haven’t yet seen what returns will look like after a complete economic cycle has passed. Also, those currently long the S&P 500 have been and still are under the risk—or certainty, given historical facts—of negative returns in the next 10 years. Given the low yields the stock market currently offers, it looks like an extremely negative asymmetric risk reward situation.

The second goal is that you’ll take a look at what you own, analyze it from a fundamental perspective, and try to estimate how your portfolio will fare through a complete economic cycle. Don’t forget that economic cycles can’t be avoided.

I firmly believe that by adding a broader perspective on performance and some fundamental analysis, long term investment returns can be increased and risks lowered.