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Future Returns on Stocks Aren’t Likely to Be as Great as You Think

Future Returns on Stocks Aren't Likely to Be as Good as You Think

We’ve all heard the old stockbrokers’ adage that equities always appreciate at 10% a year – give or take.  Unfortunately this myth has been repeated so often that many people believe it is a universal Truth.  Every year millions of us dutifully cram whatever money we can afford into our retirement accounts and invest in stocks, hoping against hope that we at least come close to that magical 10% annual return.

Unfortunately, reality can be a brutal place.  Stock returns over the next couple of decades will most likely end up barely positive, in the 0% to 3% range per annum, rather than the 10% we’ve all built our future dreams upon.  As a consequence, many ordinary people will undoubtedly find themselves working until the day they die instead of retiring comfortably as they originally hoped.

I understand that saying stocks will do badly over the next decade is a rather dire prognostication.  So what is the evidence for it?  The major predictor I use is a modified valuation formula shamelessly borrowed from deep thinker and asset manager John Hussman of the Hussman Funds:

((1+Nominal GDP Growth Rate)*(Average Valuation Metric/Current Valuation Metric)^(1/Number of Years))-1+Current Dividend Yield

In this case I like to use the S&P 500 Index as being representative of broad market averages.  I also like to use the price-to-sales ratio as my chosen valuation metric.  Not knowing what the future holds, I have created a baseline scenario and a wildly optimistic scenario.  Keep in mind that these potential return calculations only work over longer (more than 5 year) periods of time.  The stock market could easily rise or fall by double digits next year and it wouldn’t invalidate these calculations in the least.

 

If you plug in all the variables you get something like this for the baseline scenario:

((1+4.0%)*(1/1.81)^(1/10))-1+2.12% = 0.13% S&P 500 return per annum

 

And here is the wildly optimistic scenario:

((1+6.3%)*(1.41/1.81)^(1/10))-1+2.12% = 6.69% S&P 500 return per annum

 

Of course there are a lot of assumptions buried in these predictive formulae.  For one thing, it is predicated on today’s dividend yield being a reasonable proxy for dividends several years from now.  That might – or might not – be the case because dividends can increase, decrease or even be suspended.

Another sizable assumption is the nominal growth rate of the economy over the next decade.  First we’re using this number as a proxy for aggregate corporate growth rates, which I believe to be approximately true, particularly over long periods of time.  Historically, this rate has been about 6.3% in the United States.

This is the value I use in the wildly optimistic scenario above.  However, recent history after the Global Financial Crisis, as well as Japan’s experience during its (ongoing) “Lost Decade” point to a much lower value of no more than 4.0%.  I use this lower value in the baseline calculation above.

Now the heart of the matter is the valuation metric used and the assumption that this metric reverts to the mean over long time periods.  Today, the S&P 500 has a price-to-sales ratio of 1.81.  This value is – to put it charitably – absolutely insane.  It is higher than at any point since the original Dot Com bubble around the year 2000.  The S&P 500’s average price-to-sales ratio over the last 15 years is 1.43.  This is the value used in the wildly optimistic scenario above.  If we exclude the Fed induced period of serial equity bubbles over the last 20 years, then a price-to-sales ratio of around 1 would be very generous.  This is the average value I use in the baseline scenario.

These formulas also assume that any valuation reversion takes place over 10 years.  Returns can be increased or decreased by changing that time frame.  Decreasing the amount of time for the valuation reversion depresses returns while increasing the amount of time gooses them.

Now that I’ve explained the voluminous methodology and numerous caveats attached to these formulae, let’s look at the returns themselves.  The baseline scenario yields 0.13% over the next decade while the wildly optimistic scenario gives 6.69%.  I didn’t bother calculating a pessimistic scenario because I don’t want to be accused of frightening children and kicking puppies.  As you can probably guess, it would have a negative sign in front of it.

Now some people might argue that I am not factoring in future inflation.  And there is a grain of truth in this accusation.  Sharply increased future inflation is not explicitly captured in these calculations.  However, I feel sustained, high inflation in today’s debt saturated economy is close to an impossibility.  Recent history has certainly served to buttress this supposition.  In any case, inflation is not the panacea that central bankers and politician would have us believe.

This is doubly true for equity investors.  Elevated levels of inflation tend to severely depress stock market multiples (valuations).  The 1970s was a great example of this.  The equity markets – while experiencing significant volatility over the period – spent the entire decade going nowhere.  Collapsing stock valuations completely offset increased revenue and earnings due to inflation.  The only source of return during this period was an indices’ dividend yield.  Today, the dividend yield on the S&P 500 is a unappetizing 2.12%.  So I wouldn’t rely on inflation to boost your stock market returns.

In all probability, a broad equity market return over the next 10 years of much more than about 3% or 4% is hopelessly unrealistic.  This revelation means that you would almost certainly be better off holding corporate bonds rather than stocks – at least if you have a very long investment time-frame.  It also means that if you are looking for a place to allocate the risk-oriented portion of your portfolio in hopes of a return greater than 5% per annum, stocks aren’t it!

So where can the average investor find a reasonable return in exchange for reasonable risk?  Art and antiques are the secret.  This little known asset class has so far escaped both the bubble-crazed mad men of Wall Street and the demented policies of central bankers.  It represents one of the few remaining islands of value in a sea of investment junk.  And with investment-grade art and antiques starting at unbelievably low prices – sometimes as little as $100 an item – you don’t have to be a millionaire to start getting good returns on your money!

Most Collectibles Will Never Be Good Investments

Most Collectibles Will Never Be Good Investments

One mistake that a lot of well intentioned people make when first investing in alternative assets is confusing fine art and antiques with pedestrian collectibles.  Differentiating between the genuine asset class of art and antiques on the one hand and knick-knacks and collectibles on the other is vital considering that failing to do so can be a potentially very expensive error.

Art and antiques have a proven track record as investments, sometimes spanning not merely decades, but centuries.  Collectibles, in contrast, usually quickly burst into the public consciousness and then flair out of existence just as quickly.

So what makes something a collectible instead of a legitimate antique?  First, collectibles tend to be created solely, or primarily for the purpose of being sold directly to naive collectors.

Think of your Uncle Ned’s “Champions of NASCAR” plates from the Franklin Mint.  You may love your Uncle Ned dearly, but the sad fact is that his limited production-run plate “collection” has no real value, besides its vanishingly small utilitarian value as dinner plates.  They were produced by the thousand and hold no allure for most NASCAR fans, much less the average person.

Compare this to something like the Hope Diamond.  Many people may not know a lot about diamonds, but almost everybody has heard of the famous blue stone and the exciting lore surrounding it.  And a lot of wealthy people – even those that don’t normally spend much time thinking about diamonds – wouldn’t mind owning such a renowned and beautiful gem.

Collectibles also have a tendency to be faddish.  A great example of this is Beanie Babies.  Do you remember those small, cute plush animals that everyone was stockpiling at the turn of the millennia?  It doesn’t make a whole lot of sense now, but everyone was absolutely convinced that these tiny lumps of brightly-colored fabric and synthetic beans were going to allow them to retire on the French Riviera.  Once the insanity receded, the Beanie Baby fad dissipated with incredible speed, leaving tens of thousands of bitter “investors” with nothing but junk stuffed animals and regrets.

True antiques are real items that were created to be used by real people in real situations.  Life isn’t easy and that rule applies doubly to antiques.  Actual antiques have been worn smooth, accidentally dropped, forgotten in basements and attics for years and generally abused in almost any way imaginable.  As a result, it isn’t surprising that relatively few survive today.

In contrast, it is a safe bet that almost every mass-produced collectible ever made is immediately squirreled away into a dresser drawer, display cabinet or hope chest.  This ensures that, regardless of the size of a collectible’s initial production run, the exact same number is still available today – and invariably in excellent condition too.

Collectibles are often made to commemorate well-known people or events.  Why is this so?  Because the marketing team behind the collectible knows these famous individuals and occurrences are a hook.  They play upon the emotions of ignorant suckers who want to “own a piece of history”.  The only problem is that the collectible commemorating the event has no real connection to that history whatsoever.

Let’s look at an example.  What do you think most civil war buffs would rather own – a recent, mass-manufactured bronze medallion commemorating Confederate general Robert E. Lee, or his personal 1860s era officer’s side-arm, complete with provenance?  One of the items has a true, personal link to the famous man while the other is the mass-produced vision of a marketing maven with dollar signs in his eyes.  Is it any surprise that the real antique is destined to appreciate far into the future, while the collectible will eventually find its way into the trash heap where it belongs?

The Sad Truth about Modern U.S. Commemorative Coins

The Sad Truth about Modern U.S. Commemorative Coins

For the last 35 years, give or take, many nations around the world have minted a variety of commemorative coins.  In this endeavor, the United States has been the first amount equals, minting dozens of different types of commemorative pieces.  These commemorative issues have celebrated such diverse organizations, people and events as the Girl Scouts, Dolley Madison and the World Cup of soccer, among others.

However, modern U.S. commemorative coins also share one common feature; they are all, without exception, terrible investments.

One of the primary rules of investing in art and antiques is that anything intentionally issued as a commemorative item is rarely a good investment.  This dictum applies not only to commemorative coins, but to any other commemorative souvenir as well.  There are a couple reasons for this.

First, the issuing company or agency is typically interested in making a profit – the larger the better.  This means they rarely put stringent limits on the number of commemoratives they release.

The second problem is that when people buy commemorative issues the first thing they do is hide them in closets or bury them at the bottom of dresser drawers.  Consequently there is almost no natural attrition of the commemorative pieces in question.  If a million were originally produced, it is a fair bet that somewhere approaching a million are still around, and almost all of them will be in pristine condition too!

Modern U.S. commemorative coins illustrate this point perfectly.  Since the early 1980s, the U.S. mint has struck commemorative half dollars, silver dollars and $5 gold coins.  From the program’s inception in 1982 through 2014, there have been, in total, over 13 million uncirculated and 51 million proof specimens struck.  Although technically legal tender, none of these issues has circulated.

Instead, each one of them left the mint encapsulated in hard plastic for preservation purposes.  It is almost a guarantee that very close to all 64 million of these modern U.S. commemorative coins are still out there, lurking in ordinary peoples’ desk drawers and safety deposit boxes, patiently waiting for the day they can be sold at a big profit.

Unfortunately, that day is unlikely to ever arrive.  Recently I was browsing the website of the well-known bullion dealer APMEX.  They had mixed-type, modern U.S. commemorative $5 gold coins available in bulk.  These pieces are struck in 90% fine gold and contain 0.24187 troy ounces of pure gold each.

You can buy as many of these official U.S. government mint issued gold coins as you like for less than 8% over the spot price of bullion – about $23 per coin over spot.  That, my friends, is only half a step removed from the coins trading as pure bullion pieces, with absolutely no numismatic (collector’s) value whatsoever.

That isn’t the end of the bad news for modern U.S. commemorative issues, though.  With the exception of the very first commemorative half-dollar struck in 1982, all subsequent commemorative half-dollars issued by the U.S. mint are composed of an abominably cheap copper-nickel alloy.  Only commemorative silver dollars are struck from the traditional 90% silver alloy.  Of course, the U.S. mint still charges a premium price for these half-dollar issues, despite them being struck in base metal.

As if all this wasn’t bad enough, the coup de grace is that modern U.S. commemorative coins have – almost to a coin – universally poor designs.  So in addition to celebrating rather mundane or obscure topics, U.S. commemorative issues of the last few decades are also artistically uninspired, to put it kindly.  Stylistically the coins are unspeakably dull; it is obvious that the die engravers weren’t trying very hard.

It is possible that you may have received a modern U.S. commemorative coin as a gift or perhaps even purchased one for yourself or for a loved one.  I sincerely hope you do not believe that these pieces are good investments, because nothing could be further from the truth.  Possessing unattractive, lifeless designs and struck in massive quantities, these commemorative issues are best ignored and left to rot in attics and basements.

If you must speculate in them, then the deal that APMEX offers – less than 8% over spot for $5 gold commemoratives – is a great starting place.  If things end badly then all you could possibly lose would be the modest premium over bullion value.

Most Alternative Assets Aren’t as Alternative as You Think They Are

Most Alternative Assets Aren't as Alternative as You Think They Are

Alternative Assets are all the rage in the asset management business these days.  Private equity, hedge funds and real estate are all sometimes touted as the alternative assets that will, depending on the sales pitch, either protect your portfolio from the next global financial crisis or boost your returns into the stratosphere.

An alternative asset is simply any investment that is not positively correlated to the two major existing asset classes: stocks and bonds.  Investing a portion of your portfolio in alternative assets should increase your returns while reducing your risk.  That is the theory, anyway.

In reality, most of the assets considered alternative by the mainstream financial industry actually aren’t very alternative at all.  Instead these “false” alternative assets are pushed by large financial firms because the big banks and brokers already understand them well.  In other words, they are conventional assets that have been repackaged to look new and different.

Another reasons giant financial companies like “fake” alternative assets is that there is sufficient liquidity to buy or sell hundreds of millions or even billions of dollars worth of them without overwhelming the markets.  It is a case of investing for philosophical and practical convenience rather than investing for maximum return.

Private equity, for instance, refers to equity placements that are not listed on any public stock exchange.  But at the end of the day, private equity is actually just common stock in companies that cannot access the public capital markets for whatever reason – usually due to the issuing company being too small, too distressed or privately held.  This means their correlation with traditional stock markets is more or less total.  Even worse, private equity is rather illiquid due to being unlisted; buying and selling (especially selling) is difficult.

Hedge funds are a catchall for limited partnership investment vehicles targeted at institutions and high net worth individuals.  Hedge funds can invest in almost anything and pursue a myriad of different investment strategies, both long and short.  However, “investing in almost anything” is really a euphemism for investing in almost any “paper” asset.

Once again this brings us straight back to the public equity and debt markets.  Sure, hedge funds can invest in private equity too, but private equity is just common stock in disguise.  Therefore, hedge fund correlations with the broad market averages are generally very similar, unless your fund likes to go short.  But then again, you can easily short equities in your E*TRADE online brokerage account yourself.  There is no compelling reason to throw management fees at a hedge fund to do it for you.

Real estate perhaps has the best claim in the group to truly being alternative, but even this asset falls short.  When most people mention real estate, what they are really mean is developed real estate (buildings of some sort) that is rented out to tenants.  It doesn’t matter whether the real estate in question is a warehouse, mall or apartment complex; the concept is the same.

But real estate’s Achilles heel is that it is almost universally funded via debt – the ubiquitous mortgage.  So in a financial crisis, when banks aren’t granting mortgages, you can expect the value of real estate purchased with debt – pretty much all real estate – to decline substantially.  Indeed, this is exactly what we saw happen in the Great Recession of 2008 – 2009.  Unsurprisingly, this causes real estate to become very closely correlated to stocks and junk bonds during crisis scenarios.

So what are the real alternatives to these pseudo alternative assets?  The answer is art and antiques, of course.  These little known sleeper hits of the investment universe have little correlation to either stocks or bonds.  And although they may decline in value marginally in a financial panic, they will surely rebound quickly once the worst of the crisis passes.

Art and antiques are as close to an undiluted claim on future global GDP as one can hope for in this world.  But isn’t that all that any prudent investor is really looking for these days – a simple, safe, and tangible investment that will grow predictably for decades to come?