One Weird Number Explains… Everything


Today we want to expand on a theme we touched on last week: 20-year trailing returns on US stocks. Don’t yawn…. There’s interesting material here. Trust us and read on…

First a quick summary of the data, using the latest market prices:

  • Over the last 20 years, the S&P 500 has compounded at 5.52% annually on a total return basis. Inflation adjusted (using headline CPI), compounded annual returns for the S&P have been 3.4% over the same period.
  • The last 2 decades have been some of the worst for nominal long term returns in US stocks since the periods ending in the late 1970s (6.5% – 6.8% CAGRs) and the late 1940s (2.4% – 4.0%), which includes the Great Depression.
  • The reason why returns look so bad even after a decade-long bull run: two +35% drawdowns in 2008 (-36.6% total return) and the 2000 – 2002 experience (net 37.4% loss).
  • Recent history is much, much worse than prior peaks. At the end of 1999, the S&P had compounded at 17.5% nominal/13.7% real over the prior 20 years. At the end of 1962, the index had grown by a 16.7% nominal/13.3% real CAGR over the prior 2 decades.
  • Average trailing 20-year CAGRs since 1928 are 10.7% nominal/7.3% real, so the last 20 years are also well below average levels.

The bottom line: US stocks have just delivered some of their lowest 2 decades of compounded returns since the Great Depression, and that simple fact explains several macro business trends relevant to the financial services industry. 

For example:

Point #1: Low returns explain the rise of passive investing and the growth of exchange traded funds. When stocks are compounding at 11% (their long run average), asset owners are more likely to feel they can afford active management for the possibility of outperformance. When the S&P 500 is cranking along at 5% (like now), it becomes harder to justify active management fees; every basis point counts. Exchange traded funds, which can have lower reported tax impacts than mutual funds, also have an edge in the current environment.

Point #2: Low returns push equity market structure to become more cost efficient. It is no coincidence that the heyday of Wall Street trading desks was in the late 1990s, at the last peak of trailing 20-year returns. Institutional commissions of $0.05/share were an easy ask back then. Now, brokers are happy with a penny or two and that is all clients can afford in a low return environment. All this forces trading desks to become more efficient on both the buy and sell side, investing in automation to further reduce expenses.

Point #3: Low equity returns force institutional asset owners to take more risk to make required rates of return (typically 7-10%). Common wisdom holds that low interest rates, especially since the Financial Crisis, are the root cause of pension/sovereign wealth funds raising their allocations to private equity/venture capital. That’s how you end up with a $100 billion Softbank Vision Fund and their brethren spawning scores of startup “unicorns”.

The truth is that these institutions need much better than 5% compounded equity returns to fulfill their own mandates. Low returns in fixed income play a role in their allocation decisions, but it is far from the only challenge they face. US stocks haven’t delivered their historical rates of return, so they must go further afield.

Point #4: Low returns also imply a low equity cost of capital, which puts the current share buyback rage in a questionable light. Ask the typical S&P 500 CFO what his/her cost of equity capital is, and you’ll likely hear “10%”. And that’s generally the hurdle rate they use when assessing new capital investments. Any excess cash after those investments goes to buybacks. In truth, the “real” cost of equity capital is 5% and companies should be reinvesting more and spending less on buybacks.

To be fair to CFOs, they likely see lower than average long run returns through the lens of the volatility that creates them. Rather than invest in marginal projects, they try to buttress their stock’s valuation with buybacks. That’s a sensible approach in a micro sense, but markets see a macro environment where companies forsake long-term growth for short-term stock returns.

Point #5: In order to start seeing better long run returns, US stocks need a lot of new blood in the system. Recall the reason why the S&P 500 has managed reasonable gains over the last 10 years: Amazon, Google, Facebook, Apple, and Microsoft top the list. And even then, their performance only got us to a subpar 20-year track record… Imagine if they had not been in the mix.

Better than 5% CAGR returns on the S&P 500 through 2038 will not likely come from these companies, however. As attractive as they are, it is hard to see any of them doubling their market cap in the next 10 years (a 7% CAGR), let alone doing so again in the next decade after. Or dragging overall equity valuations higher in their wake…

All this explains why it will be so important to see a fresh crop of disruptive Tech companies come public in the next few years. The good news is that VCs have been plowing capital into these businesses to make them ready to go public. The bad news is that IPO windows are notoriously fickle, so we may have to wait a while if current market volatility persists.

Summing up: we don’t see trailing returns mentioned very often, but they are the lifeblood of equity markets. The only good news about sitting at the low end of a historical range (as we are now at 5.5%) is that mean reversion should start to kick in. It can’t come soon enough for our liking.

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