Can the stock market triple by 2026?

damWe often hear these days that stocks are overpriced and due for a correction. Despite the fact that the S&P 500 is hitting all-time highs after climbing 250% in eight years, it’s clear that the rally has not quite captured the heart of investors. Analysts were never really convinced either and have issued similar warnings for years. Meanwhile, the bull market marches on.

Is it too late to join in? That is certainly a risk: it is a well-known fact that investors abandon caution at the worst possible times. But when the current rally is put in context with past performance, the case for extreme caution loses some of its potency. Stocks have been known to climb far more than the 250% registered since 2009, such as when they soared 1,000% between 1942-1966 and 1982-2000. Both rallies eventually died, of course, but false calls that the end was nigh were issued many times before the bull-slaying busts finally arrived.

Booms can be confoundingly persistent. The ten-fold rise from 1982 to 2000, for example, did not ebb gradually: instead, it sped up in the mid-1990s as investors became increasingly bullish and optimistic.

Conversely, busts come along with violence, often just after people stop recognizing that markets can do just that. In the late 1990s, for example, nobody could foresee the brutal 3-year bear market that started in March 2000.

Market crashes are a feature of how markets behave, and have always been around. The 2008-09 financial crisis or the 2000 dot-com crash, for example, were no more devastating than the Crash of 1929, or the long-forgotten Panic of 1873 that forced the first stock market closure.

These booms and busts come in unpredictable cycles of different duration. Nobody has a way of forecasting market turns.

But about 90 years ago an intriguing pattern of market behavior developed, and it has held remarkably well to this day. It goes like this: weak stock market returns in a 17-year period follow 17 years of very high returns, and vice versa. This might be nothing else than a coincidence, and we do not know whether it will hold in the future. But the cycle is quite clear.

can the S&P 500 triple chart

In 1929, for example, stocks had returned a remarkable 13.4% average in the previous 17 years, the highest it had been up until that point, and investors were euphoric. But in the next 17 years stocks yielded a miserly 1.3% per year including dividends. Fast forward to 1942: stocks had returned less than 4% during the prior 17 years but went on to yield a stunning 18% annual average return during the next 17.

Since then, the market pendulum has swung between despair and euphoria, taking market returns from trough to peak. It seems that just when optimism reaches its highest point a new era begins, marked by low returns, and affirming the dictum that investor sentiment is best seen as a contrarian indicator.

Despite the market strength, conditions today can hardly be described as “euphoric”. Political dysfunction, global terrorism, rogue states and the rise of global protectionism are just some of the concerns discussed in today’s news. Sentiment is rather weak, illustrated by the prevalent idea that the stock market is too high and ripe for a fall. And the past 17-year average market return has been low by historical standards.

So, according to the despair-euphoria cycle we described, current conditions seem to be consistent with strong future returns. If so, what would it mean for market levels?

The most conservative way of measuring this is to start the calculation at the trough of 2009. To arrive thus to a 17-year average total return of, say, 15%, the S&P500 would have to be around 7000 sometime in 2026, assuming dividends of about 2% per year. A 16% average annual total return would take it closer to 8000, or well above three times its current level.

This may sound unreasonably high, but as observed earlier the stock market has gone up much more than that in the past, and tenfold twice. Going from 700 in 2009 to 7000 in 2026 would not lack precedent.

Looking elsewhere for clues we note that the last 8 years saw weak economic growth, a condition proven to be cyclical; if so, we may be on the threshold of a new period of environmentally sustainable expansion aided by new technologies (think renewable energy and artificial intelligence). This could be a shot in the arm for the global economy.

We insist: it is impossible to know whether this pendulum-like cycle will hold. The stock market moves in patterns that occasionally repeat themselves for a while and then vanish, a feature common to unpredictable systems.

Even if the pattern holds, there is nothing to prevent the market from tanking and then recover to produce a strong 17-year average return by 2026. The 20%-plus Crash of October 1987, for example, happened five years into the tenfold stock rise of 1982-2000.

So the cycle we described does not say anything about where the market may be this year or the next. But those who wonder about the long term may find the idea of being in the initial stages of a really long rally quite exhilarating.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Contact Path Financial at 941.350.7904.

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather

Limit Stock Market Losses to Improve Long-term Returns

men putting out fireInvesting in stocks can be brutal. According to research, the S&P 500 lost at least 10% from a previous high every two-and-a-half years on average, and at least 20% every six. A 30% loss happened every 13. It has fallen 50% from a peak three times since 1954. None of these declines were, or could have been, anticipated with any kind of precision, and they certainly do not come at regular intervals. And, remarkably, losses of this magnitude contradict the models we use to describe market behavior.

For example, the largest S&P 500 one-day loss was 20.5% in October 19 1987. According to a widely used model of stock market returns (which assumes that they form a bell curve around an average) the likelihood of the 1987 loss is similar to picking the right card in a deck containing as many cards as there are atoms in the known universe. In other words, the chance that such drop could happen is essentially zero.

Clearly the problem is not that impossible events happen but that our models are inadequate. A lot of analysts have tried to come up with better ones, but so far this quest has proven fruitless. We still can’t predict markets with any meaningful accuracy. This is why markets are not so much like the weather, as they are often compared, but rather like earthquakes, which scientists now admit are unpredictable.

But here is the good news: we cannot predict earthquakes, but we know how to build earthquake-resistant structures. Likewise, we cannot predict markets but we have techniques that can help us limit losses when markets tank.

There are some very basic reasons why limiting losses is more important than producing strong returns.

A well-known example goes like this: If you lose 50% of $100 you need a 100% return on the remaining $50 to break even. This means that a large percentage loss requires a very large percentage gain for full recovery.

But a far more important example is this: If you only lose 20% of $100, you will need just 25% to bring the remaining $80 back to $100. So a small loss requires much less effort to come out from it.

This is even more important for retirees who use savings to pay for living expenses.
For example, taking $10 after a portfolio falls from $100 to $50 leaves the saver with only $40. A subsequent 100% return only takes the portfolio back to $80. That means that the $10 withdrawal turned into $20 because of its bad timing.

But when $100 only falls to $80 and $10 are taken, a subsequent 25% recovery on the remaining $70 brings the value up to $87.50. This means that the $10 withdrawal turned into $12.50—a much smaller penalty for taking money out at the worst possible time.

The moral is clear: limiting losses is an essential element in portfolio management.
Limiting losses requires some basic processes in place. The best known is diversification, or investing in a mix of assets that tend to move in different directions. But a mix that looks diversified today may not be diversified tomorrow, especially when markets take a turn for the worse. This is because in down markets investors sell everything and correlations go up sharply. Therefore, a mix that does not take into account how the market cycle changes is prone to go through periods where diversification goes away just when investors need it most.

Adapting portfolios to market conditions requires dedication, patience, and a well-designed set of rules. This is, or should be, the professional portfolio manager’s job. Some investors insist that the portfolio manager’s job is simply to beat the market by picking a high proportion of winning assets. Accordingly, they are willing to pay a premium for those managers who seem to have the hot hands. This is a bad approach, commonly known as “chasing past returns.”

Many studies show that virtually no active fund can consistently beat its benchmark, and not because of fees. According to Standard & Poor, which publishes a regular analysis of fund performance, most funds underperform their benchmarks both before and after fees.

The simple explanation is that poorly diversified funds can only outperform their benchmarks through superior forecasting. But, just like for earthquakes, forecasting the market accurately is impossible. As one academic put it:

Going back to basics, the idea “to invest successfully in the stock market, you need to know whether the market is going to go up or go down” is just wrong. (Professor David Aldous, UC Berkeley – The Kelly criterion for favorable games)

While limiting downside exposure is crucial in portfolio management, having this protection in place at all times can be frustrating. If the market keeps on rallying, the “insurance” against declines appears to be an unnecessary drag on returns, just as going through the expense of building a house that is earthquake-resistant may seem like a waste as long as there are no earthquakes.

We all have complained about paying for insurance that we don’t seem to need. This is understandable as long as disaster does not strike. But the temptation to cancel insurance can be dangerous. If you are not yet convinced this is so, please reread the first paragraph to see why having a systematic process to protect investments from losses is a good idea.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours.

We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather

A silly story that investors should ignore

Path Financial President and Chief Investment Officer Raul Elizalde

Path Financial President and Chief Investment Officer Raul Elizalde

Have you heard the one about how bad it is to miss the top-performing market days?

It goes like this: If you miss just a handful of the market’s best days, your portfolio returns will be significantly reduced. For proof, the story comes with a chart that compares being invested in US stocks every single day versus missing a few of those top days.

One version of that chart shows that $100 invested in the S&P 500 since inception (from January 3, 1950 through February 20, 2015) would have grown to $12,667. Missing the top 5 days, however, brings the end value to just $8,203, or 35% less. Missing the top 25 days gets a miserable $2,966, or 77% less than just leaving the portfolio alone. The conclusion seems inevitable: it is a bad idea to cash out of the market for any period of time, lest you miss those crucial days.

As it turns out, this argument is seriously flawed. But because it has been parroted over and over, it has gained undeserved credibility. What’s wrong with it?

Continue reading

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather