Preparing For Lower Returns

John Bogle, Cliff Asness, and Ray Dalio are just a few of the juggernauts that have recently been vocal about expecting lower returns. What is an advisor supposed to do when people like this are all on the same side of a very important issue?

Here are a few ideas:

  1. Lower your expectations, literally. In the financial plan, you can lower expected returns and or adjust inflation upward. Stress test the portfolio. Any plan that can’t succeed with lower temporary returns is destined to fail.
  2. When they’re warning of lower returns, they’re mainly talking about U.S. stocks and bonds. The easy answer to this potential problem is diversification. Emerging markets and developed markets Ex-U.S. have been dead money for over a decade.The chart below shows the ratio of the S&P 500 to MSCI EAFE; you’ll notice the relative outperformance of U.S. stocks is significant.


  3. Explain to clients that we just lived through a period of low returns! Over the last 15 years, the S&P 500 has compounded at just 2.5% a year. This is lower than 85% of all rolling fifteen-year returns. However, we’re simultaneously coming off a period of really strong returns, over the last six years anyway. Compounding at >12% a year makes the last six years better than 81% of all rolling six-year periods for the S&P 500.
  4. What does “lower expected returns mean?” Bogle is not anticipating lower returns for the next thirty years, he’s looking out over the next decade. Fortunately, most investors have an investing horizon much greater than ten years. Pound this message home; we don’t know what returns will be going forward, but we do know that the odds of negative returns decreases with the passage of time.


Lower returns might very well be in the cards. The good news is that nobody actually knows, they’re guessing like you or I. The better news is that  lower returns provide the foundation for higher future returns. Thinking and acting for the long-term while surviving the short-term is perhaps an advisor’s most important role.

The Upward Drift

Cliff Asness is out with a new interesting paper, “Market Timing Is Back In The Hunt For Investors.” In it, he discusses the efficacy of using valuations, specifically the CAPE ratio, to help time the market. One thing Asness addresses is the valuation drift upward which U.S. stocks have experienced over the last century.

Here’s Cliff:

“As alluded to earlier when discussing the long-term upward drift in CAPE, another related but distinct headwind for contrarian stock market timing in the second half of our sample has been the decades-long valuation drift in post-World War II equity markets, over which the CAPE gradually doubled. The average CAPE for the decade immediately following WWII was 12.4, while the average CAPE since the year 2000 has been over 25.”

He then addresses the oft-heard argument that this valuation drift is a secular change.

“There’s always the additional risk that these secular changes are not just random wanderings, which will eventually work themselves out, but justified permanent changes in levels. That is, perhaps the CAPE is higher, but we should never expect it to go back to historical levels. This is a well-known ‘the world has changed’-type argument. While we tend to be natural cynics, as these arguments abound and are often wrong, they certainly can’t be dismissed.”

I do think there is some validity in the argument that stocks deserve a higher multiple today then they did at the turn of the 20th century. To understand why, let’s go back and look at America’s first billion dollar corporation, U.S. Steel. In 1902 they employed 168,000 people and had sales of $561 million. In today’s dollars, that’s ~$15.1 billion.

One of the reasons I believe we’ve seen an upward drift in valuations is because of the improvement in efficiency and productivity. Today, 175 S&P 500 companies have more revenue than $15.1 billion. In 1902, U.S. Steel had $3,340 in revenue per employee, which is $90,000 in 2014 dollars. Today, U.S. Steel’s revenue is $493,000 per employee, 5.5.x the amount it was in 1902.

Of the 52 S&P 500 companies that make this metric readily available, only one has sales per employee less than $90,000.

sales per emp

Not only has productivity vastly improved, but many of the frictions of trading have disappeared. Today, you can buy $100 million dollars worth of the S&P 500 with the push of a button and nobody would notice.

Along with improved productivity and trading execution, accounting standards have been a game changer. For much of the long-term CAPE averages, investors had little idea about a company’s actual financials. How much would you pay for $1 of suspected earnings when accounting laws didn’t exist?

With millions of Americans shoveling money into their retirement plans every month, there is a much greater demand for stocks than their was in the first half of the twentieth century. In roughly half of the long-term CAPE ratio, mutual funds, which brought stock investing into the main stream, didn’t even exist.

To be sure, I don’t think it’s impossible that we never see single digit valuations again, who could be so sure of such a thing. But getting back to the question of whether you can time the market based on valuation, I think that’s extraordinarily difficult. Consider that over the last 25 years and 925% return, stocks have been above their long-term CAPE average for 293 out of 309 months. While higher valuations absolutely do mean lower future returns, it’s all but impossible to know when to expect them.

When stocks look pricey, the best thing for most people to do is adjust their expectations accordingly. Making a habit of going in and out based on valuations is probably not going to help you build your wealth.

Do People Want to be Fooled?

“Magicians are the most honest people in the world. They tell you they’re gonna fool you, and then they do it.”
-James Randi

I recently watched “An Honest Liar” on Netflix, which is the story of The Amazing Randi, a magician and escape artist who dedicated his life to unveiling the charlatans. He went on a crusade, targeting the “psychics” and faith healers and exposed them for the con artists that they were.

In the film, there was a scene where Peter Popoff, a self-proclaimed prophet and faith healer was speaking to a room full of people.


When he calls out for Rosa and Kipper, a woman and her child stand up. “You have a lump in your chest? Stand up! God’s gonna burn that thing out right now!”

How could this stranger know about this boy’s illness? Is God speaking directly to him? Well no, but his wife is, right into his ear. We hear her say into a hidden earpiece “Hello Petey, can you hear me? If you can’t, you’re in trouble.”

Randi couldn’t sit by and watch these people be taken, conned out of their money and filled with false hope. He exposed these thieves, freeing his victims from the illusion that they or their loved ones were about to be healed.

But then a funny thing happened.

The crowd turned on Randi. It turns out that people actually wanted to be lied to. These poor, dying people needed the illusion of a higher power. The fact that their wishes were being granted by a snake-oil salesman was no concern of theirs.

There are many parallels between the world of cheap magic and finance. People are often being swindled by the promise of ridiculous returns. There is an endless supply of financial magicians out there, exhibit A, these guys.


The brilliant Jason Zweig, The Amazing Randi of finance, recently touched on the topic of people who want to be deceived.

“Three ways to get paid for your words:
1) Lie to people who want to be lied to, and you’ll get rich.
2) Tell the truth to those who want the truth, and you’ll make a living.
3) Tell the truth to those who want to be lied to and you’ll go broke. ”

There is a gigantic pool of people out there who want to be believe in the unbelievable. They want to be told that they can beat the market.

I’m putting on my Amazing Randi hat and calling out a “white paper” I recently came across. This is from a large asset management company which manages almost $100 billion. Below, I highlight some true, yet deceptive claims.

“Active management has typically outperformed passive management during market corrections, because active managers have captured alpha on the upside.”

Not true. In a study by Vanguard conducted in 2008, they found that actively managed U.S. funds have outperformed the broad market in just three out of the six previous bear markets. Note that in 2008, 54.3%, 74.7% and 83.8% of all large-cap, mid-cap and small-cap funds underperformed the index.

not true

It turns out that the percentage of funds outperforming during bull markets (in brown) has yet to exceed 50%, refuting the statement that “active managers have captured alpha on the upside.”

not 2

“When the current bull market inevitably turns, passive managers could be left holding stocks and sectors with poor fundamentals and inflated valuations. Meanwhile, active managers have the ability to mitigate risk by reducing exposures to expensive areas that will be hit hardest, and conversely, increase exposure as sectors or asset classes recover to capture upside as the new market cycle begins.”

What is this gobbledygook?

Being that we don’t know when the bull market will “inevitably turn,” why don’t we look at some actual numbers. Not a single actively managed mutual fund style has outperformed their benchmark over the last one-year, three-year, five-year or ten-year period.

true 3

“Facts are facts, whether you’re an active or passive manager.”

Alright, this is true.

“In the funds lineup, 21 out of 36 equity and fixed-income funds outperformed their largest ETF competitor during two or more of the following time periods: Year to date, 1 year, 3 year, 5 year, and 10 year.”

Wow! It’s pretty impressive that they’ve managed to outperform in at least two of those time periods. Oh wait a minute, if we take a closer look, there are five time periods. Suddenly, 21 out of 36 funds outperforming in at least two out of the five time periods isn’t so impressive.

Here is the mother lode of suspicious claims.

“From 2000 to 2009, active outperformed passive nine out of 10 times.”

They’re not lying, it’s just a sleight of hand. What you’ll see in the disclaimer, which is of absolutely no use to the laymen, is that their active funds are “made up of funds from the Morningstar Large Blend category that are not index or enhanced index funds.” What this means is, and I don’t know how they’re quantifying this, is that outright index funds or managers that closely resemble index funds are eliminated from inclusion. Fine, that makes sense. But then, they cross the line. They compare these funds to the “Morningstar S&P 500 Tracking Category.” I don’t know what’s in here, but I do know it’s an expensive way to represent the S&P 500.

The S&P 500 proxy they used (below in red) underperformed the Vanguard 500 by 0.63% a year from 1985-2014. The active large blend funds they’ve selected sure seem to be cherry-picked, based on the fact that they outperformed the cheap index over a 30-year period. I just don’t buy this. I’d love to know what percent of funds have been excluded from their composite.


Which brings us to the people on the other side of the table. The people who want to be lied to.

Most investors don’t want to be told to expect average returns. Who wants to be average? Surely you can do better if you try a little harder. Unfortunately, there is a really bad misconception that market returns aren’t going to cut it. With investing, being average can actually be extraordinary.  My partner Ben Carlson recently showed that the worst thirty-year period ever for the S&P 500 was 850%! Don’t be fooled, if only people were able to receive average returns over the course of their lifetime they would do fantastic!

Lest anyone misconstrue what I’m trying to say, here are a few caveats:

  1. I have no idea what stock returns will be over the next thirty years. It’s entirely possible that we experience worse returns going forward than we have in the past.
  2. I’m a big believer in active management, there are some amazingly talented people out there.
  3. The vast majority of people in the financial services industry are not trying to deceive their audience.

Right Place, Right Time

Amazing things can come to people that work hard, persevere, and are lucky enough to be born in the right place at the right time. Malcolm Gladwell talks a lot about this in his book Outliers: The Story of Success, in which he explains why two-thirds of Canada’s pro hockey players were born in January or February.

Expanding on the idea that when and where you’re born are everything…

The industrial titans and financiers of the Gilded Age were born between 1835 and 1839. That list includes Andrew Carnegie, Jay Gould, J.P. Morgan and John Rockefeller All of these men came to power in a time which experienced the most rapid economic expansion in our nation’s history. If this crop came along fifty years later, they would have came into their prime just in time for the Great Depression.

How about some of the legendary value investors? Art Samberg was born in 1941, Leon Cooperman in 1942 and Mario Gabelli in 1943. These three each began their careers in earnest when stocks were trading at single digit multiples and competed with double-digit interest rates. Finding value was the name of the game.

Then there are the godfathers of modern technology. Paul Allen was born in 1953, Sun Microsystems founders Bill Joy and Scott McNealy were both born in 1954 and Steve Jobs and Bill Gates were both born in 1955.

Can anybody will themselves to become one of these outliers? Sure, all you need are 10,000 hours and the good fortune to be born in the right place at the right time.

Necessity’s Mother

Guns, Germs and Steel is one of the most fascinating books I have read in a while. Jared Diamond masterfully tells the story of how and why civilizations have developed differently across the globe. I wanted to share a passage which questions the common thinking that “necessity is the mother of invention.”

The starting point for our discussion is the common view expressed in the saying ‘Necessity is the mother of invention.’ That is, inventions supposedly arise when a society has an unfilled need: some technology is widely recognized to be unsatisfactory or limiting. Would-be inventors motivated by the prospect of money or fame, perceive the need and try to meet it. Some inventor finally comes up with a solution superior to the existing, unsatisfactory technology. Society adopts the solution if it is compatible with the society’s value and other technologies.

Quite a few inventions do conform to this commonsense view of necessity as invention’s mother. In 1942, in the middle of World War II, the U.S. government set up the Manhattan Project with the explicit goal of inventing the technology required to build an atomic bomb before Nazi Germany could do so. That project succeeded in three years, at a cost of $2 billion (equivalent to over $20 billion today). Other instances are Eli Whitney’s 1794 invention of his cotton gin to replace laborious hand cleaning of cotton grown in the U.S. South, and James Watt’s 1769 invention of his steam engine to solve the problem of pumping water out of British coal mines.

These familiar examples deceive us into assuming that major inventions were also responses to perceived needs. In fact, many or most inventions were developed by people driven by curiosity or by a love of tinkering, in the absence of any initial demand for the product they had in mind. Once a device has been invented, the inventor then had to find an application for it. Only after it had been in use for a considerable time did consumers feel that they ‘needed it.’ Still, other devices, invented to serve one purpose, eventually found most of their use for other, unanticipated purposes. It may come as a surprise to learn that these inventions in search of a use include most of the major technological breakthroughs of modern times, ranging from the airplane and automobile, through the internal combustion engine and electric light bulb, to the phonograph and transistor. Thus, invention is often the mother of necessity, rather than vice versa.

A good example is the history of Thomas Edison’s phonograph, the most original invention of the greatest inventor of modern times. When Edison built his first phonograph in 1877, he published an article proposing ten uses to which his invention might be put. They included preserving the last words of dying people, recording books for blind people to hear, announcing clock time, and teaching spelling. Reproduction of music was not high on Edison’s list of priorities. A few years later Edison told his assistant that his invention had no commercial value. Within another few years he changed his mind and did enter the business to sell phonographs- but for use as office dictating machines. When other entrepreneurs created jukeboxes by arranging a phonograph to play popular music at the drop of a coin, Edison objected to this debasement, which apparently detracted from serious office use of his invention. Only after about 20 years did Edison reluctantly concede that the main use of his phonograph was to record and play music.

The motor vehicle is another invention whose uses seem obvious today. However, when Nikolaus Otto built his first gas engine, in 1866, horses had been supplying people’s land transportation for nearly 6,000 years, supplemented increasingly by steam-powered railroads for several decades. There was no crisis in the availability of horses, no dissatisfaction with railroads.

Because Otto’s engine was weak, heavy, and seven feet tall, it did not recommend itself over horses. Not until 1885 did engines improve to the point that Gottfried Daimler got around to installing one on a bicycle to create his first motorcycle; he waited until 1896 to build the first truck.

In 1905, motor vehicles were still expensive, unreliable toys for the rich. Public contentment with horses and railroads remained high until World War I, when the military concluded that it really did need trucks. Intensive postwar lobbying by truck manufacturers and armies finally convinced the public of its own needs and enabled trucks to begin to supplant horse-drawn wagons in industrialized countries. Even in the largest American cities, the changeover took 50 years.

Inventors often have to persist at their tinkering for a long time in the absence of public demand, because early models perform too poorly to be useful. The first cameras, typewriters, and television sets were as awful as Otto’s seven-foot tall gas engine. That makes it difficult to foresee whether his or her awful prototype might eventually find a use and thus warrant more time and expense to develop it…

If you need any more convincing, this book is on Charlie Munger’s reading list. Check it out.

Source: Guns, Germs and Steel: The Fate of Human Societies

Youtube: Guns, Germs and Steel