Should we "Curb Our Enthusiasm"

By Jon Aldrich

2019 was a great year for stocks, bonds and virtually every investable asset class. This was a welcome follow up to 2018, when virtually every asset class except cash went down. The nice thing, though, is that just about everything went up much more in 2019 than they went down in 2018. Markets were also extremely calm and there was not a lot of volatility since that big whoosh down at the end of 2018, which seems like a distant memory now. All in all, it was one of the best years in a long time for investors. Too bad they can’t all be like that.

However, as investors, we have to be careful to not get too excited and expect results like we had in 2019 to continue in the years ahead. Fact is, stocks (and bonds for that matter too) have had an exceptional run since the lows of 2008-09. Except for 2018, the last 10 or 11 years have been one heck of a party for investors, however, stock valuations are really getting on the high side of historical valuations and bond yields are quite low, just look at the paltry 1.7% yield you get currently on the 10 year U.S. Treasury Bond. This is not exactly a recipe for stellar returns over the next several years.

Source: Bloomberg

The above chart is considered to be Warren Buffet’s favorite indicator of how cheap or expensive the U.S. stock market is. It is a very simple indicator that is a ratio of the total value of the U.S. stock market divided by the U.S. Gross Domestic Product (GDP) which is a measure of the output or total value of goods and services produced in the U.S. The higher this ratio, the more expensive the stock market is. You can plainly see that we are not quite as high as we were in 2000 (although the latest quarter’s market results are not shown in here yet) but it is in the same neighborhood. There are other indicators as well that show that current U.S. markets are pricey as well.

I don’t want to be Debbie Downer and be the guy that put the “you know what” in the punch bowl, but we should probably temper our expectations for market returns the next few years. This does not mean stocks have to crash, but it is entirely possible that markets could experience a whole lot of ups and downs the next couple of years and not make much progress to the upside.

In their latest market outlook, Vanguard also believes that things will likely be subdued for some time:

Source: Vanguard

We are currently in the longest economic expansion in history which means we have gone the longest period of time between recessions. Could it go on for a while longer, sure, but at some point in time we will have a recession, the Federal Reserve has not eliminated market cycles. And, in actuality, recessions are healthy for the economy in the long term as they wash out the excesses and speculation that can build into a bubble. You remember how fun the Dot Com bubble was in 2000 and the Real Estate bubble was in 2008, right?  True, recessions are generally not a great experience, but they are much more preferable to a crash, and bubbles often lead to market crashes.

So, what does this all mean? Just because the prospects for U.S. stocks and bonds may not be as rosy as we would like, there are still some areas that may offer better opportunities going forward. International and emerging markets stocks (see the purple and orange lines in the chart below) have not moved up nearly as much as the U.S. has (see blue line in chart below) the last 10 years or so and are comparatively much cheaper.  Real Estate funds and Emerging Market Bonds might also work, and even though bond yields are currently low, bonds still generally hold up well when the stock market is not doing so well, so they will almost always have a place in your portfolio.

Also, take a look at the stock market returns by decade below. Just because we had a really good decade doesn’t mean that the next decade will be a washout either. Take a look at the decade after the 1950’s and the 1980’s. The 50’s and 80’s were decades when stock market returns were greater than 10% annually and the following decade’s returns were still pretty solid. But, also, see the decade after the 1920’s and 1990’s and you will see lousy returns for the following decade, so maybe it comes down to about a 50/50 chance that we will have paltry returns in the decade of the 2020’s. But that also means there could be a 50/50 chance that we have another decade of solid returns.

What this all boils down to, is that we shouldn’t be drastically altering our portfolios. A globally balanced, diversified portfolio should help smooth out returns whether we have a good or poor decade or something in between. It also is a good time to re-visit your asset allocations and make sure they are aligned with your long-term needs and goals. This would include reviewing a likely range of outcomes to the downside and upside with your current portfolio and estimating the expected long-term return.

I don’t know what the next decade holds for us in regards to the markets, and I really do hope we have another solid decade, but we also need to be prepared for market returns possibly being much lower than what we are accustomed to. In the financial plans that we prepare for our clients, we take this possibility into consideration by using lower than historical market returns in our plans. If the plans work with these lower returns, then clients do not have to fear reduced returns and can accept that there will be times that this occurs and may last for several years.

Ironically, as I am writing this the S & P 500 is down over a full percent, this is the first time in about 4 months that the market has moved more than 1% up or down. Please don’t blame me.