Dear Valued Clients and Friends,
For the second time in the last couple of months, I am going to call an audible and not publish a Dividend Cafe on the artificial intelligence moment and its relevance for investors, despite having announced I was doing so the prior week. I have actually been assembling and digesting research on this topic for many months and am quite excited for the final product to appear in Dividend Cafe. But it is too important of a topic and an issue I have worked on now too much to publish prematurely. I was in New York City the first two days of this week, Dallas the next two days, and am in California now. Between a massive amount of meetings, events, portfolio activity, flights, and all the things, I was engulfed in a different topic this week instead of finishing my other piece.
This week’s topic is pretty darn important, though. In fact, I believe it serves as the macro story of our moment. It brings in some very important history and how to think about the past in the context of the future (not exactly an old or stale topic for those who remember last Friday), but it also allows us to understand what is going on right now in a broader and more extended sense. I think where interest rates go over the next ten years matters (also a fresh topic on our minds). Still, one could argue that everything going on right now has to do with the cycle we are in, had previously been in, and the question around where we ultimately go.
So let’s hang tight on artificial intelligence and investing a little longer because this week, we have to cover a tale of two decades. It will take you ten minutes to really appreciate ten years. Let’s jump into the Dividend Cafe …
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Starting with the conclusion
In a nutshell, I believe this decade will be the decade of teaching many investors one of the most important lessons they will ever, ever learn:
The decade of the 2010s was an exception, not the rule
That sentence alone is good enough if you want to check out now and go get mentally ready for the USC-UCLA game.
But if you want to fight on, here is a little more unpacking of the meaning behind it. I do not mean that it is rare for the stock market to go higher. It does that far more than otherwise, especially if we are talking about a full ten-year period (indeed, 94% of rolling ten-year periods over the last hundred years are positive). And I also do not mean to suggest that the 2010s were devoid of volatility, whereas most periods have volatility, because, candidly, the 2010s had plenty of volatility. A near -20% drop in mid-2011. A mid-day -9% drop (flash crash) in 2010. A near -20% drop in late 2018. I believe there were 57 incidents of 2-5% drops. And outside the calendar year reality that paints a better picture, there was a mid-year to mid-year two periods in the middle there that saw a flat return. So, investors had some waves to ride last decade.
But, there are some market dynamics that were also hyper-spoiled in terms of volatility, too. Let’s start with the easy one. Ummm – the market was up every single year. So there’s that. Now, actually, that isn’t true – because in 2018, the S&P was down -4.38%, so that was negative. But I mean, not really. -4% as the worst year in a whole decade barely registers, and by the way, by the time one had cleaned up their New Year’s party in early 2019, that -4% drop of 2018 was erased.
Not only did you have no down years besides one barely down year that recovered just days into the next year, but you had the lowest up/down volatility year ever in 2017. You had an annualized return of 13.6% per year in the S&P 500, roughly 3% per year better than its annual average entering the decade – a 357% cumulative return. And yes, the “standard deviation” last decade (the variance around the average return) was several points below the annualized volatility of the market for the prior 70 years.
Add in the bond market (3.65% per year for ten years), and a basic 60/40 investor still got 9.7% per year for the decade, with more or less no down years in the bond market (one negative year for long bonds and one negative year for corporates; no down years for short-dated treasuries). Rates went down nearly every year, pushing prices higher even as coupons fell year over year.
Okay, so it was just a really, really good decade for asset prices. Stocks – up. Bonds – up. Housing – up. All real estate – up. Good times. And so, so easy, right?
Our conclusion: The decade of the 2010s was an exception, not the rule
And to start, we won’t even look at asset prices – we will look at basic economic reality.
The 2010 that was
How were U.S. household balance sheets doing out of the Global Financial Crisis (GFC)? Tathered, beaten, and nasty – that’s how. Home prices had fallen. Debt was high. Ratios were bad. Household balance sheets had nowhere to go but up after two years of liquidation.
Was there a lot of new investment going on in 2010? No, there was none, which is to say it had nowhere to go but up (whether that “up” came because of a Fed-induced reflation of the corporate economy or not).
Growth was paltry – averaging barely 1% real GDP growth for a while and never even getting to 2%. Double-dip recessions were discussed all the time because economic growth was so weak it was never going to take much more than a tiny nudge to tip it over.
Housing entered 2010 massively, unfathomably over-supplied. Too many people had bought houses they couldn’t afford, and too many houses had to be returned to the banks. A foreclosure and default cycle like we had never seen was playing out, resulting in way fewer homeowners and way more homes available.
Wages were not growing much, adding to populist angst domestically and abroad. It was, at best, a period of muted wage growth, especially for the middle class.
Unemployment was over 10% to start the decade.
The 2010s launched as a period of really weak economic macro conditions.
The good side of the coin for 2010s
Are you confused yet? How did such economic macro conditions lead to the period of investment returns I just described?
$4 trillion of quantitative easing helped. Nearly an entire decade of 0% interest rates helped. A P/E ratio that started closer to 13 before going closer to 20 was a monumental part of it (because of math). Stocks and bonds had a low correlation which enabled asset allocation to work in a traditional context and attracted capital in both major asset classes. Reflation post-GFC enabled massive corporate profit growth. It would be harder to describe a better environment for asset prices.
Summary of the 2010s: Ideal conditions for investing macro; sub-optimal conditions for economic macro
And then there was 2020
We did not have a major world event from 2010-2019. From 2000 to 2009 saw the 9/11 attacks and the Global Financial Crisis. The 2010’s saw, what, Arab Spring? Brexit? The Cleveland Cavaliers win a NBA title? That Malaysian criminal guy party with Leonardo DiCaprio? It just wasn’t a decade of global drama on par with most decades.
2020 sort of reversed that. Globally. Politically. Medically. Economically. Culturally.
But let’s not spend our time here talking about COVID because it did end, and while it delayed the moment of economic transition we are in now, it did not erase it.
How can we contrast the beginning of the 2020s right after COVID to the beginning of the 2010s?
Household balance sheets are in stellar shape: higher net worth, way more equity, way more savings, way less leverage.
Wages are growing about 4% per year net of inflation.
There is no supply – none – for housing.
Unemployment was 10% in 2010; it is barely 3.5% now.
Globalization is in sharp reverse, at minimum in rhetoric and intention, and very likely in some form of real life as well.
In many ways, the economic macro of now is the polar opposite of where we were to start the last decade.
Investment deja vu in the new decade
Instead of starting this decade with cheap stock valuations, we started with high ones.
Instead of starting with $60 earnings in the S&P 500, we started with $200.
Instead of starting with a 4% ten-year bond yield, we started with a 1% ten-year bond yield.
Instead of negative correlation with stocks and bonds, we have hyper-positive correlation between the two.
Instead of $60 oil, we have been over $75 most of the last three years.
In 2021 and 2022 together, stocks averaged 5% per year, not almost 14%. Even with the FAANG-heavy 2020 factored in, the S&P sits at 9% per annum, well below the prior decade’s return, with far more volatility.
What does it mean?
Many things are re-anchoring to a pre-GFC reality, not the post-GFC decade that was so problematic in economic macro and ideal for risk assets.
Many things are now re-anchoring to pre-COVID reality, where huge disruptions took place that made economic and market calculation impossible.
Many return and risk realities are reverting to the mean, rendering the 2010s the aberration they were and forcing investors to re-think strategic asset allocations.
And so what does that mean?
It means stock market indices may hem and haw, forcing people to wonder why October was down and November up and not realize that two years have gone by with no market movement at all. It screams for pre-2010 thinking, where it is expected that markets will have extended periods of drawdown, not 11 years of easy-going.
It forces investors to allocate far more to alternatives when stocks and bonds are so positively correlated unless diversification and non-correlated sources of risk and return are no longer a desirable thing.
It forces investors to rely less on passivity and more on cash flow growth.
It recalibrates expectations to the realistic.
Which is to say, not the 2010s.
Quote of the Week
“The line separating good and evil passes not through states, nor between classes, nor between political parties either – but right through every human heart – and through all human hearts.”
~ Alexandr Solzhenitsyn
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So my “artificial intelligence, Nasdaq 2000, and investing wisdom” Dividend Cafe will not be coming this coming week either since this coming week is, well, Thanksgiving! We will have a special, annual Thanksgiving Dividend Cafe in your inboxes on WEDNESDAY, but after that we hope that everyone will be checked out of their inboxes and checked into their families and turkeys. I know I will be. There will be a DC Today on Monday, but not Tuesday (and then Div Cafe on Wednesday with the long holiday weekend to follow). It is one of the great weeks of the year!
Fight on, Trojans, and may all of you have a delightful “weekend before Thanksgiving week.”
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
