### In the Long Run …

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With that preface, on to the show …

What is a reasonable expectation for long run US equity returns? The market history we all learned in finance class or on the job provides one approach to answering that question:

• Since 1928 the S&P 500 has averaged an 11.8 percent annual total return (price appreciation plus reinvested dividends).
• The standard deviation of those annual returns is 19.4 points.

Conclusion: while any given year’s returns might be quite choppy, over the long run you should expect to see (round numbers) a +12 percent annual return. At that rate, capital doubles every 7 years.

Throw in inflation, and the math looks like this:

• US CPI inflation has averaged +3.1 percent since 1928.
• Post-inflation S&P 500 total returns therefore have averaged 8.7 percent.

Conclusion: after inflation, capital invested in US large cap stocks has historically returned about 9 percent, on average doubling in real spending power every 9 years.

So, how do the last 20 years of S&P 500 returns stack up against this math? You’d expect that 2 decades would be long enough to see historical norms play out. But, no:

• Assuming the S&P 500 closes the year with a 23 percent total return (its YTD gain), the index’s compounded annual total return since the start of 2002 will be 9.2 percent.
• Assuming CPI inflation averages 4 percent this year, the S&P’s post-inflation 20-year compounded annual return ending 2021 will be 7.0 percent.

Conclusion: over the last 20 years, the S&P 500 has underperformed its long-run simple average total return by 2.6 points and its post-inflation long-run return by 1.7 points.

That seemingly small difference – 2.6 points – translates into a large gap in investment outcomes:

• Invest \$1 million at a compounded total return of 11.8 percent (the long-run simple average) for 20 years and you get \$9.3 million at the end of that period.
• Invest \$1 mm at a compounded total return of 9.2 percent (actual last 20 years), and you get \$5.8 million.
• The difference: \$3.5 million. Yes, on a \$1 mm initial investment. Compounding is a powerful thing …

This chart shows rolling 20-year compounded annual total returns (nominal in blue, real in red) for the S&P 500 back to 1947, and it puts some historical context around today’s discussion:

#1: Trailing 20-year S&P compounded returns are rarely in line with the index’s long run simple average. They can be higher than 12 percent (1957 – 1970, 1993 – 2004), or lower than 12 percent (1971 – 1992, 2005 – present). But 12 percent is rarely the actual result and the difference in long run results can be dramatic (as shown in our million-dollar example above).

#2: Peak 20-year compounded returns (1961: 16.7 pct, 1999: 17.7 pct) occur under two very specific circumstances:

• The first is wartime. The former (1961) included powerful 4-year equity rallies during World War II (1942 – 1945, 25 pct CAGR) and the Korean War (1949 – 1952, 23 pct CAGR).
• The second is during periods of declining rates and speculative bubbles. The latter (1999) was a combination of steady equity returns as interest rates came down in the 1980s – 1990s (1982 – 1994, 14 pct CAGR) and the late 1990s dot com bubble (1995 – 1999, 28 pct CAGR).

#3: Trough returns, unsurprisingly, occur when US equities experience a +30 percent drawdown over one or several sequential years across a given 20-year window.

• The first low point on the chart above is 1948 (2.4 pct CAGR), which includes the 65 percent decline in the S&P 500 from 1929 – 1932.
• The second is 1982 (6.8 pct nominal, 0.9 pct real), which includes the 37 percent decline in 1973 – 1974.
• The last was just in 2018 (5.6 pct) and includes both 2000 – 2002 (-37 pct) and 2008 (also -37 pct).

As mentioned in the introduction, we’ve thought about this chart a lot over the years because its timeframe and long-run perspective capture not just investment themes but a wider set of issues. A few examples:

#1: While there is a distinct sine-wave pattern to the 20-year historical return data, the drivers of exceptional returns vary greatly across time. The early-1960s peak was war-related. The late-1990s peak was macro (lower rates) plus the Internet 1.0 bubble.

Therefore, while it is tempting to look at that chart and say “Aha! We’re heading into a new golden age for US equities”, we need a better reason than just “it always happens this way”. You will not be surprised to know that our upside narrative is anchored in disruptive technology. The performance of Apple, Microsoft, Amazon, et al is the most notable reason the S&P 500’s 20-year returns have started to turn in the last 4 years. Nothing outside of Technology has the power (both in terms of S&P weighting and incremental profitability) to keep that trend going.

#2: While trailing long-run returns may be rearview mirror-thinking, they certainly inform where asset owners put their capital. Indexing and low-cost exchange traded funds took off in the early 2000s and only grew in popularity after the Financial Crisis as it became clear structural US equity returns could not support high active management fee structures. On top of that, institutions shifted capital from public equities to private and venture capital over the same period. All that fits with the idea that if long-run (20 year) returns in US stocks is poor, you need to go elsewhere to maximize portfolio returns.

This is one overlooked reason why there is so much venture capital money in the system right now and, even if current deal valuations look untethered from reality, that’s OK as long as a few of these companies become the “the next big thing”. Perhaps US Big Tech can continue to power the S&P 500 to +15 percent annual returns for the next 5-10 years, but an easier path would include seeing some new names start to contribute as well.

#3: Wall Street can only be as healthy as its clients’ returns allow it to be. When trailing long-run returns are only 5-8 percent, as they were for much of the 2010s, investors will be very cost conscious about everything from management fees to trading commissions. Perhaps now that we’ve had 3 years of +15 percent returns, some of that pressure will abate and give the equity business a bit more pricing power.

#4: Just 1-2 years of outsized drawdowns can still fundamentally alter long-run S&P 500 returns. Granted, there have been only 5 such periods in the last 100 years: the Great Depression, 1937, the 1973 – 1974 oil shock, 2000 – 2002, and the Financial Crisis. Each, however, reset stock prices down by at least a third and three of the five have happened in living memory.

Given how important the US stock market is to the consumer wealth effect, we can understand why the Federal Reserve will always do what it can to limit the possibility of a +20 percent stock market loss. That happened, if only briefly, last year. It’s not just the market’s signaling effect that worries them; it is also the effect a large drawdown has on total long-run investment returns.

Summing up: rather than assume that US equities compound at “X” rate, the more productive analysis is to identify the factors which make them rise or fall over time. We are bullish on US equities for the next 20 years, but only because of the power of disruptive innovation to remake business models and deliver incremental corporate earnings. A 12 percent annual return on the S&P 500 is not pre-ordained. In fact, it rarely occurs.

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