Peter’s 10-Year Market Hypothetical

When you are a self-directed investor and you see your current portfolio take a dive and all the market news goes negative… Well, welcome, you’re in a bear market.

We’re not saying a bear market is something to fear, nor that you should not invest during one. After all, market timing is fraught with lost opportunities. But, there is a chance (considering said bear status) that stock market returns in the next 10 years may be lower than the previous 10.

Let’s break it down

Markets are very imperfect indicators of what is going on in the short and mid term. Stock markets and most other markets tend to overshoot on both the up and down sides. However, when you look at the very long term, things become clearer. We can learn from that perspective to become more astute investors.

In the long run, the market is a weighing machine of the predictability of cash flows that companies as a group churn out. Basically, the market grows in the long term because of growth of profits. So, how can one grow profits? Well, mostly through productivity advancements (innovation) and growing prosperity in the world, as this increases the number of markets companies can sell to.

If you look at a 30-year period, for example 1992-2021, the average return of the S&P 500 was 9.9%*. To get to your net return, you have to deduct inflation, which ran just above 3.2% per year over that period. So, using these figures, you could expect to get a return of around 6.7% during your 30 years of wealth accumulation.

During that period, the productivity growth was 2.3%, according to St.Louis Federal Reserve, so that leaves 4.4% of return unexplained. However, you can explain this 4.4% by saying that this is the cost of capital.

In the long run, investors can get a 4.26% return (or net 1.1% after deducting inflation) on a 10-year Treasury bond with barely any risk. Therefore, the market has to return more because it is riskier. Hence, we can deduce that this market risk premium is about 3.3%.**

Why is this important? Well, in the past 10 years, the return of the S&P 500 has been significantly higher than average. Over the last decade, the S&P 500’s average annual return was around 14.7%, with a historical below average inflation of 2.44%. Why? Well, Milton Friedman argued, “Inflation is always and everywhere a monetary phenomenon,” and a lot of economists have been unable to dispute that.

Now, it sounds even more important to realise that the money printing during the GFC and the COVID crisis is finally finding its way into inflation, as predicted.

Anyway, let’s suppose the S&P 500 is going to revert over the next 10 years: the returns should be around 4.8% and with a current inflation of 8+% (hopefully declining soon). In this hypothetical scenario, your next returns over the next 10 years might well be around zero. How depressing!

What does this mean for the young investor?

Market timing isn’t something investors should try, as most research shows that investors lose money and opportunities that way. That doesn’t mean that you should blindly do what’s worked in the last 10 years either though, things like crypto, high tech stocks, and consumer discretionary spend brands. Netflix is down almost 60% in the past year, Peloton almost 90%, and as an aggregate indicator, the Nasdaq is down over 23%.

Yet, you should keep investing to build wealth for the future. So, you may want to skew toward sectors that are more inflation-proof and that have shown to do better in stagnated economies or periods of recession.

Here is where we believe at Unhedged that algorithmic investing may, in certain circumstances, get better results than a static unbiased portfolio. For instance, the Unhedged Sector Rotation algorithm started to overweight Utilities, Commodities and Staples from December 2021. It did so automatically, with no human interference – just machines and data at play. This algorithm has also been the best performer so far since the launch of Unhedged.

What does this mean for the older investor?

When you are preparing for retirement, and the above sounds reasonable, you might want to make sure your exposure is more towards yield products that are inflation-protected than in high-flying tech stocks. A financial advisor will be happy to evaluate your personal situation and render advice.