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The Year Ahead (and beyond)

By December 19, 2019No Comments

As we enter a new decade, I thought it was appropriate to take a look at the past one as well as my expectations for what’s to come specifically in the investment world. I can only imagine there will be countless technological breakthroughs during the next 10 years just as we saw over the previous 10 and am excited for the ones that move humanity forward and not just ones that keep us glued to a phone (or whatever tech comes next). Before we get into 2020 and beyond, let’s take a quick stroll through memory lane.


The past 10 years saw incredible gains in the US stock market as few expected the record breaking rally. If you recall the feeling of 2010, it wasn’t one of euphoria. I recall the days of 2011 and 2012 vividly and discussing with many investors that not a lot had changed from the years before the crisis. What did change and what had a major impact was the incredible global stimulus efforts to prop up economies and a seeming unwillingness to allow any recession to occur. The US Fed added trillions of dollars to their balance sheet while countries like Japan drove interest rates negative and bought stocks. Europe joined in on the negative interest rate party and drove bonds deep into negative territory. At one point, rates were negative out to 50 years in Switzerland. I don’t know anyone who would have guessed we would have ended 2019 as far away from 2010 in equity markets or bond markets, especially here in the US. We’ve reached new market highs despite high valuations, rising headwinds and slowing growth. The US’ valuations as compared to the rest of the world and historically are high to say the least. International markets haven’t fared as well and have yet to eclipse their 2007 highs. As a result, their valuations are looking more reasonable as compared to the US.


The 2000’s started with a burst of the dot com mania with the Nasdaq retreating 80% and the S&P retreating significantly, although not nearly as much since it wasn’t as heavy in tech stocks. It was a prolonged decline with the market finally bottoming in 2003. During this time, the Fed cut its benchmark rate to 1% and kept it there for quite some time and likely set the stage for the next financial crisis and post financial crisis interest rate policy (low rates for a long time). With low cost of capital and excess risk taking abound, we sowed the seeds for a real estate crisis which burst in 2007-2009 plunging the world into a global financial crisis. Through the Fed’s interest rate policy and various quantitative easing programs, the markets rapidly recovered and eventually reached new highs in 2013.

This past decade almost topped the 1950’s, 1980’s and 1990’s where they generated above average returns. The 2 decades following the 50’s and dot-com bust were not as generous and produced mid single digit returns to slightly negative. The reason I would argue for the 50’s and 80’s high returns were the starting valuations at that time in the market. January 1, 1950 the S&P 500 PE was under 8 and ended around 18 at the end of the decade (see chart below). In 1980, the starting PE was similar at 8 and then produced 2 decades of high annual returns before ending with sky high valuations from the dot-com era before leading to slightly negative returns the following decade. As for the 2010’s, I’d argue it was relentless global stimulus which produced this decades outlier returns. And as we enter a new decade with a PE ratio over 20, it’s hard to imagine how the US markets will produce meaningful returns over the next 10 years. The only way I see high returns is for some reason we have a technological breakthrough which leads to dot-com style euphoria where valuations are ignored.

PE ratios over time

Diversification in the New World

From 2000-2010 the S&P barely eked out a positive return and by adding international stocks to your portfolio, the return was much improved. Fast forward to the period of 2010-2020 and diversification did the complete opposite. If you had most other asset classes (international stocks or otherwise), it ended up being a ball and chain around the portfolio; dragging down returns which could have been higher. Diversification is still relevant, however, from my perspective it has its regimes where it works better than others and forecasting these regimes is seemingly impossible.

BUT, diversification is something I’m not sure one can achieve anymore with traditional stock and bond portfolios. Owning a portfolio of small, mid and large cap US stocks mixed with international ones doesn’t provide you a great deal of diversification (imho) (more on diversification below). That’s because they’re all stocks and generally move in the same direction each day, albeit with varying magnitudes (high correlation with varying betas). **Disclaimer** You should still be diversified in traditional ways by owning global stocks due to shifting regimes. However, there are some ways to add additional levels of diversification which we’ll go into.

The way the most indices are organized (market cap weighted) can create a momentum factor where the big keep getting bigger and drive the overall returns for the entire index. The top 20 stocks account for over 30% in the S&P 500 index while the bottom 300 stocks only account for 18% or so. So what are you buying when you own the S&P 500?

Intuitively, your largest holdings in a portfolio should be the ones with the highest risk adjusted return expectations. However, indices are just not constructed in this manner. At least not the ones you hear most often. This has opened up a new investment philosophy/strategy called factor investing and/or alternative indexing. I believe that in order to achieve greater public market diversification, the addition of these alternative public market strategies can possibly help a lot.

The simplest alternative index is the equal weight index (imo). Instead of weighting the S&P 500 by market cap, you assign each stock the same weighting. What this does is gives you greater exposure to smaller size companies in the S&P while underweighting the largest ones. In times where the big stocks keep growing (as referenced above), it can be an anti-momentum strategy as the equal weight index sells stocks that are continuing to rise and re-weighting them equally (ie buying the stocks that haven’t risen as much to bring the weightings back to equal). When stocks fall in the index, it acts as a mean reversion strategy by buying more of them to bring their weight back up. In some instances, it will also look like a buy low, sell high strategy. And the results look promising as you can see from the chart below.

And this is the tip of the iceberg for factor and alternative indexing strategies. As of today, we’re using price reversal, moving average, cash flow and seasonality factors in portfolios. Although I imagine this will grow over time as more research is conducted.

Potential Disruptors in the 2020’s

I am incredibly bullish on many things but I tend to focus on downside protection. So at a high level, these are the things that give me cause for concern for 2020 and the decade ahead:

  • global economies’ unwillingness to have a recession and their seeming willingness to do anything to keep their stock markets and economies “from losing”. In doing so, we continue to kick the can down the road on problems that need to be solved while at the same time creating new and bigger issues in the future.
  • higher than average US stock market values (PE ratios, price to sales ratios, market cap to GDP, etc., etc.)
  • shifting population out of high tax states like California and Illinois further stressing state and municipality finances and ultimately leading to municipality defaults
  • the large amount of debt rated BBB and covenant-lite loans
  • continued stress in the repo markets causing other unintended consequences
  • the mountainous amount of unfunded pension liabilities in the US
  • the deficit which has spiraled out of control
  • large amounts of US debt and US debt/GDP ratio
  • negative rates abroad suddenly spiking and going positive
  • US interest rates spiking due to inflation or a lack of faith in the dollar causing deficits to increase further from higher interest expense
  • rising populism and an ever widening gap between the wealthy and the poor
  • continued partisanship in the US and an inability to collaborate to solve big problems
  • and I think the biggest concerns I have are environmental ones; rising temperatures causing wildfires, melting of polar ice caps, deforestation and cutting down rainforests, etc. There are too many to list here and I truly hope we can reverse course and mitigate damage we’ve already done but it starts with all of us taking action today in countless ways. A basic first step is eliminating single use plastics, composting to restore soil depletion in the US, a move to regenerative agriculture to restore the soil as well and aide in carbon capture and the list goes on.

Why am I cautious on US stocks?

Some charts to paint a narrative

Since you know how much I love charts, below are a variety of charts which illustrate why I’m cautious heading into the new decade.

Where you buy an asset class can have a large impact on your future returns. GMO is a very well respected research firm that comes out with asset class forecasts regularly. For some time now, their 7 year return forecasts have been showing low to negative real returns (returns after inflation) projected in the US. This is because of our current valuations in the US stock market. If they’re correct, emerging markets specifically look to be a much better place to invest.
Within the US, there’s been a divergence of returns comparing value and momentum stocks (growth). This has been the longest streak of momentum outperforming value and makes you wonder if you should be tilting your portfolio towards value and betting on mean reversion.
This is an interesting chart which looks at the median PE ratio for the S&P 500. Based on this metric, we’re firmly in overvalued territory and far from the single digit PE’s we saw in 1981 which was the start of a long running secular bull market which lasted until 2000-01.
This chart looks at the stock market capitalization as a % of GDP at the bottom in red. Peaks in the ratio resulted in future recessions and falling valuations (and stock prices).
As I mention above, market cap weighted indices cause investors to be more concentrated than they sometimes realize. The top 5 names in the S&P 500 (Apple, Microsoft, Google, Facebook and Amazon) is about 17% of the S&P now, the highest since 1999. Maybe this means nothing. But perhaps it doesn’t.

Rising share prices in the US are driven by multiple expansion (or contraction) and EPS growth). It’s not always linear and can be lumpy. In bull markets, EPS growth is positive but the PE usually expands as well. It can start in single digits like in 1981 and end in 2000 at stratospheric levels. If earnings growth is 10% and the market rises 10% that year, the PE ratio doesn’t increase. However, in 2019, PE expansion (stocks rising above earnings growth) accounted for about 92% of returns so far.
Forward looking PE ratios are most often used I find when people talk about valuations but I prefer looking at the Net Trailing PE since analysts tend to be overly optimistic about future earnings at companies. By this metric, the PE is definitely above long term averages, but not yet near the dot com peak. However, we are higher than we were during 2008 so this metric alone should not be trusted without taking into context other variables.
Bear markets can be painful. There’s no easy way to say it. It can take a long time to recover from them and if you’re retired and need to withdrawal from your portfolio, it can cause a death spiral of value leaving you with less funds than you planned. The average bear market loss is 42% during recessions which lasted 22 months. However, it can take much much longer for the markets to fully recover. It took 10 years after the dot-com bust for the S&P to hit new highs. In Europe, the market is still lower than it was after the global financial crisis
Immigration is a hot button topic these days. However without it, we are going to struggle growing our economy. Population growth is a large driver of growth and for the next 10 years, census forecast is that native born working population will slow as baby boomers retire and there’s not enough children to replace them. Which is why we need a strong immigration policy to offset the decline.

As we enter a new year and a new decade, I wish for everyone to be prosperous, happy, fulfilled and stronger financial position than the previous years.

Best Regards,

Jared Toren
CEO & Founder

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