Three items today, still in our holiday week-shortened format:
1: What will the S&P 500 return over the next 20 years? One might be tempted to say, “11 percent annually”, since that is the average annual total return for the index back to 1928. Put into the simplest framework this means that, for every $100 invested today, an investor would see another $700 in gains over the next 2 decades.
The funny thing is that history shows the S&P rarely compounds at 11 percent annually over 20 years. Returns over a generational span can be as good as 17-18 percent annually or as bad as 2-7 percent. The former compounding rate adds $2,300 over 20 years for every $100 invested. The latter delivers only $240 in gains for every $100. Huge difference, that …
This chart shows the 20-year annual compounding rate for the S&P 500 back to 1947 (i.e., 1928 – 1947, and every sequential 2-decade period since). The blue line represents nominal returns. The red line is real returns, adjusted for Consumer Price Index inflation. The last data point ends in 2021, where we have used a 29 percent total return for the S&P 500 and a 6.9 pct CPI inflation rate (November’s observation).
A few thoughts on this chart:
First: there is a comforting sine wave-type pattern to this data, but we should not take that for granted as we consider future returns. Yes, the narratives around peaks and troughs are obvious enough (at least in retrospect):
- The peaks (1961, 1999) line up with the World War II/post-war US economic boom and the great bull market of 1980 – 1999, first propelled by lower interest rates and later by the Internet 1.0 dot com bubble.
- The troughs (1948, 1978, 2018) coincide with long-lasting economic dislocations (the Great Depression, 1970s oil shocks/inflation, sequential bursting of dot com and housing bubbles).
But … as much as one wants to see the line on that chart as inevitably moving up and to the right over the next decade (because it has twice before), one still needs to craft a sensible story about why that should be the case. Compounded annual returns above 11 percent happen for a reason. Unilateral victory in a world war. Inflation in structural retreat plus a powerful wave of investment in a new technology. What is the story from here to 2040? Hold that thought for a moment …
Second: declining long run returns tends to push capital away from US public equities, and increasing returns tends to pull capital back into them. To our thinking, it’s no accident that the last 20 years has seen institutional capital move into private and venture capital and out of US large caps. Ever-lower long run returns left asset owners looking for riskier alternatives to improve overall portfolio returns. On the flip side, readers of a certain vintage (similar to our own dusty bottle) will remember that equity money flows were very strong in the late 1990s. And we’re seeing the same phenomenon now, of course, as long run returns start to perk up again.
Lastly: long run equity returns shape the ecosystem around US stocks. When trailing returns are rising/high, money management fees can be larger than when they are falling/low. That’s one underappreciated reason why low-cost exchange traded funds have grown so quickly in the last decade.
Takeaway: even as forward-year projections always get a lot of attention in December, we think it’s worth taking some time to consider a (much) longer investment horizon. On its face, the 20-year return chart is a promising one; we seem to have turned a corner. At current valuations and interest rate levels, however, we can’t tell a story like 1980 – 1999. We are left, therefore, with a storyline about US companies continuing to dominate the global economy such as during/after World War II. That inevitably means an ever-greater slice of worldwide corporate profits going to current (and future) US Big Tech, with other American industries playing a supporting role. This is, by the way, why we focus so much on where venture capitalists are putting money to work. It is the quality and quantity of their investments over the last/next 10 years that will likely determine which direction that 20-year return chart will take between now and 2040.
2: An update on what we’ve been calling the strangest Google search volume charts out there: US consumer searches for the words “cheap”, “coupon” and “discount”. They are strange because, despite fast-rising inflation, search volumes for each are declining.
Here is the Google Trends chart showing search volumes for the words “cheap” (blue line) and “coupon” (red line) from January 2020 to now.
- As noted in the chart, searches for “cheap” hit their peak at the start of the pandemic (March 2020) and saw similar levels in March 2021 as inflation started to become evident. Since then, however, search volumes for “cheap” have come down almost 50 percent. Even holiday shopping couldn’t get consumers interested in finding lower-priced gift options.
- “Coupon” search volumes, which would include any sort of online coupon, look very similar to “cheap”. The peak came around Holiday 2020, but search volumes during Holiday 2021 were barely half those.
And here are US search volumes for “discount” over the same 2-year timeframe. The peak was in the 2020 Black Friday week, with search volumes down 21 percent during 2021’s final week of November. Searches for “discount” just made a 2-year low, as noted on the rightmost part of the graph.
Takeaway (1): as much as US consumers may think about inflation (and numerous surveys show they clearly do), they are not yet responding to higher prices by seeking out better deals. We think there are 2 reasons for that. First, Google Trends data is an aggregate reading and since overall US employment/wage growth has improved in 2021 it is reasonable to expect fewer searches for lower-priced goods and services. Second, that same employment/wage growth makes it easier for consumers to afford higher prices. Adding words like “cheap”, “coupon” and “discount” to their online searches is not yet necessary.
Takeaway (2): this is good news for US corporate earnings power, especially among larger companies which also enjoy economies of scale and scope. Consumers may complain about inflation, but they don’t seem to be changing their buying habits very much. This allows companies to pass through cost structure inflation, preserving margins and returns on capital. We don’t expect this phenomenon to last forever, but it is certainly in place as we start 2022.
By Jessica Rabe
How would IBM-Watson-powered artificial intelligence set up a US equity portfolio for 2022? There’s an ETF to answer that question, AIEQ, which we occasionally review given its novel approach to stock selection. It uses algorithms rather than human decision making, and has a solid performance track record. As always, we want to disclose that we both own a small position in this product ourselves, but otherwise have no affiliation with the fund, its sponsor, or anyone else associated with it.
Let’s begin by looking at returns versus US large and small cap equities, as well as a tech-tilted benchmark over the last year:
- 2021 year-to-date return for AIEQ: +17.8 pct
- QQQ: +28.0 pct
- S&P 500: +27.4 pct
- Russell 2000: +13.8 pct
- 3-months for AIEQ: +0.9 pct
- QQQ: +11.6 pct
- S&P 500: +10.0 pct
- Russell 2000: +0.8 pct
- 1-month for AIEQ: -2.4 pct
- QQQ: +2.7 pct
- S&P 500: +4.2 pct
- Russell 2000: +0.0 pct
Takeaway: AIEQ has lagged the S&P 500 and Nasdaq this year, but it has outperformed US small cap equities. AIEQ was actually beating US large/small caps and the QQQs year-to-date during much of September and October, but has lost ground over the last couple of months. Our regular reviews of this ETF show that it quickly changes both the number and types of holdings to include better performing names, but it’s always on the hunt for new ideas.
AIEQ uses proprietary algorithms to choose its investments, so we can’t ask a manager why certain stocks are in the portfolio or why they sold down a given position. But we can still look at its current top ten positions and see how they’ve changed since our last review on November 10th. Here they are and their weights:
- Advanced Micro Devices (AMD, 4.9 pct weight): Semiconductor company
- Palo Alto Networks (PANW, 4.6 pct): Cyber security service provider
- Dexcom (DXCM, 4.5 pct): Medical device company
- Eaton Corp (ETN, 4.4 pct): Power management company
- Fortinet (FTNT, 4.1 pct): Cyber security solutions
- Nutanix (NTNX, 3.2 pct): Cloud computing company
- Avantor (AVTR, 3.1 pct): Chemicals and materials company
- Iron Mountain (IRM, 3.1 pct): Enterprise information management services company
- CBRE Group (CBRE, 3.1 pct): Commercial real estate services company
- McKesson (MCK, 3.0 pct): Distributes pharmaceuticals and provides health information technology, medical supplies, and care management tools
- Total weight of top ten holdings: 38 percent
Here are our takeaways from this data:
#1: AIEQ continues to lighten up on its Big Tech exposure, with none in its top ten positions. That is rare, as AIEQ tends to heavily favor household-name tech just like the S&P 500.
- In our mid-September review, Apple, Microsoft, Amazon and Alphabet were its top 4 positions and made up nearly a quarter (24.4 pct) of the ETF. It did not own Facebook.
- In our last review towards the beginning of November, just Microsoft, Alphabet and Amazon were sprinkled throughout the top ten list, accounting for 14.8 pct of the ETF. Apple also went from the number one weight at 7.7 pct in September to just 34 bps. It still did not own Facebook.
- Now, the only Big Tech company this ETF owns is Apple (2.3 pct weight). Another notable company missing: Tesla, which was a top ten holding during our April and mid-June reviews earlier this year. It was also its 11th highest weight in our early November review.
#2: As for what AIEQ currently likes, it’s a bit of a mixed bag. The only overlapping theme in its top ten positions is cybersecurity, with the rest spanning everything from cloud computing and commercial real estate to medical devices and the semiconductor industry. The rest of the pad varies as well. Last time we looked in early November, AIEQ heavily favored Energy. Denbury, Chevron and National Fuel Gas represented a tenth of the ETF and were are all top ten names. Now, they’re no longer on the list.
#3: AIEQ pared back its cash position after it started maintaining more than we usually see it hold back in September. When we looked in mid/late September, it increased its cash position to 2.8 pct from 33 bps during our August review. That showed a more cautious approach in keeping with the elevated level of volatility usually associated with September, in contrast to wanting to be fully invested during this past August’s bullish environment. AIEQ continued to hold 2.8 pct in cash this past early November, but it has put more of it to work since which makes sense given that the S&P is near record highs.
Bottom line: we find AIEQ is an interesting case study for asset allocators and stock pickers because its investment process differs from traditional approaches but still delivers solid results. We may not know why the ETF is favoring certain names, but it provides a list of ideas from which to conduct further research. AIEQ has been diversifying its holdings in a host of industries and putting most of its capital to work. That’s in contrast to this past September, for example, when it placed more concentrated investments in well-known companies amid that choppy month for US equities. This latest approach reflects the current positive investment environment with the S&P near record highs.