My crystal ball is certainly no better than anyone else’s in forecasting just about anything (just look at my NFL football pool results), let alone how the U.S. equity market is going to perform over the next day, week, month, and year. But, by looking at how the S&P 500 has performed since 1926 (when it consisted of 90 stocks until 1957 when it went to 500) through to November 30, 2019, one can get a “rough” idea how it will perform in the next 10-years based on how it performed during the prior 10-year period. Why? There has been a regression to the mean tendency exhibited in this market with the exception of the strong equity market of the 1980s that was followed by an even stronger 1990s period.
For example, the strongest positive differential between a prior 10-year period and the subsequent 10-years occurred in 1948 where the earlier period produced an “average” return at 8.3%, but the subsequent strong period of the 1950s had the next 10-years outperforming by more than 13% per annum. On the flip side, 1998 was the only year-end that had a 10-year performance greater than 20% per annum. It shouldn’t have come as a surprise that the following 10-years produced the weakest results for a decade at 0.7% or -19.4% worse per year than the 10 years ending 1998.
Why do I bring this up now? Well, the prior 10-years ending November 2019 has the S&P 500 generating a 13.8% annualized return that is well above the long-term expectation for stocks. What does the future hold? Might we get the next 10-years behaving similarly to that of the 1990s that produced more exceptional performance or are we likely to see a regression to the mean pattern similar to all the other decades? As a matter of reference, outside of the six 10-year periods of the mid to late 90s and 1950’s subsequent 10-years, there have been 28 10-year periods that had the prior 10-years producing 13% or better annual performance only to have the subsequent 10-years produce worse results. The average underperformance for the next 10-years was -7.7%, which would suggest that the next 10-years may produce a roughly 6% annualized return from equities – not very impressive, especially if your ROA is still in excess of 7%.
Should we continue to see strong equity market returns through 2020 and into 2021, the prior 10-years will look even more robust. As one can imagine, the greater the prior 10-years the weaker the subsequent 10-years have been, with many following decades being 10% or more weaker than the prior period. Given the steady economic picture for the U.S. and the declining likelihood of an impending recession as the U.S. government continues to provide abundant stimulus ($1 trillion annual deficits for the foreseeable future), I am not suggesting that this party has run its course. However, it has gotten long in the tooth. Why not take some risk off the table, especially since bonds have also enjoyed a lengthy period of outperformance.
We’d suggest that you bifurcate your asset allocation into two buckets – beta and alpha – in which the beta assets are used to cash-flow match near-term Retired Lives liabilities chronologically, while the alpha assets have now been given time (10-years) to meet future liabilities. This strategy will help DB plans migrate through choppy periods of performance without forcing liquidity to meet benefit payments where that liquidity isn’t naturally found. This implementation is especially important for those plans that have incorporated significant exposure to alternatives, both equity and fixed.
So I repeat, I haven’t a clue when the equity markets will begin to underperform, but at some point, they will, as they always have. Given how strong the prior 10 years have been, the next 10 years are likely to be weaker. Why wait until you are in the midst of a correction to adopt a de-risking strategy? Call me, as I’m happy to discuss my thoughts in greater detail.