The Next Ten Years: Investing During and Beyond COVID-19
Key Points – The Next Ten Years: Investing During and Beyond COVID-19:
- Today’s Market Valuations
- The New Normal?
- Debt, GDP, and Economic Tailwinds
- Upside, Downside Capture
- 14 minute read | 18 minutes to watch
Dean Barber: Welcome to the Monthly Economic Update. We have an extended program for you today. I’m joined by David Mitchell, Regional Director for Alliance Bernstein. We’ll detail what’s happening in the economy, what’s happening in the market, and taking a look forward at what we can expect.
The Next Ten Years: Investing During and Beyond COVID-19
Dean Barber: We’ve been talking for the last several months about how the markets are overvalued. We want to get Alliance Bernstein’s take on this, so David, welcome. Thanks for joining me here for the Monthly Economic Update.
David Mitchell: My pleasure, Dean.
Today’s Market Valuations
Dean Barber: All right. You guys are in the same camp. We have markets that are overvalued. Looking at Figure 1, what is this showing us?
David Mitchell: Thanks, Dean. I think a lot of the consensus out amongst our peers and your peers are that markets are overvalued to some extent. The question is: Relative to what? Always. We were thinking of a different way we could make this point maybe come to life a bit.
I want to draw the viewers’ attention to the left-hand chart in Figure 1. Suppose we think about the last two years, my joke is that 2020 was 2020 and felt like four or five years. A lot of folks forget about 2019. 2019 was actually a great stock market.
Dean Barber: Right.
David Mitchell: Driven not so much on fundamentals, but off the Fed’s reversal, going back to low monetary policy. This is saying that coming into this year, 2019 and 2020, you can see that because of COVID, both the real economy, measured by GDP, was negative for two years, ’19 and ’20. That’s how bad the pandemic-inducing economy was last summer.
The financial economy measured by earnings of Fortune 500 companies was negative, yet the stock market was up cumulatively 55%. Obviously, the market was looking through the pandemic and still going up in the face of really challenging news in both the real economy and the financial economy.
Where are we this summer? That was coming into of the year. The good news is we’ve recovered. We’re positive in aggregate for the last two and a half years now but look at the market. It’s gone up even more. We’re back in the green for the real economy, but the financial assets are up almost 80%. To say it another way, we think we’ve already been paid a lot of this good economic growth and recovery in the form of stock prices. The question is, where do we go from here?
How Far into the Future Have We Already Been Paid?
Dean Barber: Right. How far into the future have we been paid?
David Mitchell: That’s the question.
Dean Barber: Have we been overpaid? I think that’s really, even the more concerning question is because you tend to see the markets go in a pendulum format.
Sometimes they swing too far or go too high, and then they turn back to the other side. Then we have the panic selling, and the Great Recession, and the Dot Com Bubble, and those types of things, so where are we today? Where do we go from here?
Is the Expansion Going to Continue?
David Mitchell: To make the point, we show that even earnings expectations are very high right now. I get a lot of the street, or the market expects earnings to recover and continue in an expansionary mode.
Looking back at Figure 1 at the chart in the middle, we are priced so expensively. Again, this is trailing 12 earnings. You come back here. What we’re saying here, the only thing I want your viewers to take away is that this was when S&P 500 was priced at $4,250. If the S&P 500 price didn’t move at all for the next year or two, and earnings hit exactly as advertised, really good, we’re still looking at a market trading in the 85th percentile for expensiveness.
There’s only 15% of times that it was cheaper than this. That’s how much we think we’ve already been paid. Again, we’re looking out to 2024 that even if the market went sideways, it would take us almost three to four years to get back to an under 20 PE earnings, which 16-ish, has been your long-term average.
Dean Barber: You could have a sideways market, not a bear market or a market correction, and we get back to a reasonable earnings ratio within three years.
The New Normal?
David Mitchell: That’s correct. Now, the question is, is this the new normal? Is 22, 23 times earnings with interest rates so low the new normal? We can speak to the interest rates too, but it’s always, again, when someone tells me, “Dave, something’s expensive,” whether it’s gold, or stocks or a shirt, I say, “Well, relative to what?”
Dean Barber: Right. We both know this, that just because markets are overvalued doesn’t mean that they’re going to fall tomorrow, or next week, or next month.
David Mitchell: They can stay overvalued for a long time.
Dean Barber: They can. They have from a historical perspective.
David Mitchell: Absolutely.
Dean Barber: Back in 1996, when Alan Greenspan said we had irrational exuberance, he was right. The markets were overvalued, and they continued for another four years.
David Mitchell: Right.
Dean Barber: Not just a little bit, but on a tear.
David Mitchell: That’s right.
Dean Barber: So it could continue.
David Mitchell: Right.
Debt, GDP, and Economic Tailwinds
Dean Barber: Let’s move on here. All right. Dave, let’s talk about the tailwinds fading as our debt structure grows, which is a big concern for many people.
David Mitchell: It is. A lot of folks are talking about this. In our podcasts, we talked about the cocktail of events or themes born in and around 1980 and drove the market for nearly two decades. We talked about demographics and globalization, interest rates falling forever and ever. Revolving credit, as you like to point out, and low-interest rates.
This is just making the point that, as we alluded to in 2019, you and I, before the pandemic hit, there’s still a lot of secular headwinds waiting for us on the other side of this bridge.
We know we will have a good recovery this year and earnings to GDP probably into next year in 2022, at least the first half, maybe the entire year. Once you start to look out further than that, many things that drove growth throughout the entire world for decades are beginning to fade.
Market Tailwinds are Fading as Debt Grows
We’re just making that point here in Figure 2, through declining GDP, specifically demographics, as we have aging populations in most advanced countries. You and I like to talk about this, the boomers versus the millennial handoff and transition.
Globalization, which had been a significant contributor, has plateaued. Many countries are being demanded with this populous streak within the whole world of spending more money and looking more inward instead of onshore and bringing jobs back from overseas.
That’s a current we’ll be looking at. And then finally, to your point, a growing debt burden. It hasn’t mattered yet because interest rates are still so low. And, issuing debt right now, you’re effectively being paid to borrow money, which is mathematically tough to get your mind around.
How long that lasts, and does the bond market always choose to price debt this cheaply as our debt burden grows? It could be a problem in the future.
Ultra-Low Interest Rates and Increasing Debt
Dean Barber: Well, and you and I both know, David, that a lot of the reason why the markets have been fueled the way that they are is because of these ultra-low interest rates, which has in turn, spurred the massive amounts of debts that we have.
David Mitchell: Absolutely, both in the public and private sector. Countries have been paid to borrow. If you’re a CFO of a company, you’ve been paid to borrow money and buy back your own stock or invest in research and equipment. When interest rates are low, when you pay people to borrow money, they borrow money.
Highest Market Valuations Since the Dot Com Bubble
Dean Barber: Right. I think you and I can both agree that the markets have not been as overvalued as they are today, really even going back to the Dot Com Bubble.
David Mitchell: Since the late ’90s, it’s probably been the last time you saw the markets this extended.
Dean Barber: Exactly right.
Sequence of Returns and Looking at the Past
Let’s talk about what it looks like to move forward with expectations. You’ve got a great chart here that talks about the sequence of return risk. One of the things that happens to people is they tend to use what I call recency–
David Mitchell: Recency bias.
Dean Barber: Yeah, recency bias. They think about what I have experienced in the last five years, or what have I experienced in the last ten years? They expect that’s going to continue. “That’s what the next five years will be like, or that’s what the next ten years will be like.”
You have a chart here that blows that up. It’s powerful, and it’s frightening at the same time. Let’s share with our viewers here what we’re looking at.
David Mitchell: This is something that we often think about from more of a financial planning perspective. Which I know what you think about all day. For someone in retirement in the 2020s, how different might that look and feel to someone that retired in 1990, 30 years ago, or even just 10 or 12 years ago? As I’ll show it here in a minute.
The saying that we have at Alliance Bernstein is that we think the way you win over the next decade and beyond is not just by trying to maximize the level of returns but by controlling the path of returns. At the end, we’ll show in ways in which that matters from a financial planning perspective.
Dean Barber: You’re going to control the drawdown in bad cycles.
David Mitchell: Correct. That’s exactly right. I’m a football guy, “The best offense is a good defense.”
Dean Barber: Right.
A Critical Juncture for Baby Boomers Early in the Retirement Cycle
David Mitchell: Here’s the point. We know that returns from 1990 to 2020 stock market returned double digits. The bond market, even high-quality bonds, returned high single digits of 7%, 8%. It was a beautiful thing.
My point here, if you look at the turquoise line in Figure 3, if you retired in 1990, returns were so good, you could double the rule of thumb. The 4% rule says that you can take 4% out of your portfolio a year.
Dean Barber: So you’re taking 8% a year.
David Mitchell: Eight percent a year. We jacked up the spending rate just to show, make a point essentially. You could spend 8% a year, and even with the ’08 drawdown because returns were so good in the ’90s, you still finished, and in year 30, with almost double your money.
Dean Barber: I was right at the beginning of my career. I started in 1987, and in the 1990s, they talked about an 8% withdrawal rate as a safe rate of withdrawal.
David Mitchell: They weren’t crazy! They weren’t crazy!
Dean Barber: But then, it worked. Now show somebody retiring in 2008. That’s your green line in Figure 3, right?
No One Wants to Run Out of Money in Retirement
David Mitchell: Again, the point we’re making here, same total level of returns for 30 years. I can nuke this retirement plan by changing one thing. All I did was I changed the sequence. You start 2008, and you put 1990 where ’08 was, so you’re just changing two years in the order.
Looking at the green line in Figure 3, using the same 8% withdrawal rate, the plan, you go from $2 million at the end of retirement to the plan runs out of money at year 25. You won’t even get to year 30.
Dean Barber: If you think about it, David, that’s everybody’s worst fear, “I’m going to run out of money in retirement.”
David Mitchell: That is.
Going Beyond Buy and Hold
Dean Barber: When we’re in a position where we are today, I think it’s a legitimate concern. I think it will have to go beyond just simply, “Buy and hold and do a systematic rebalance on occasion.”
David Mitchell: It’s going to have to, as I’ll show here in a second. In this lower-return world, advisors and money managers like Alliance Bernstein will have to get more creative in ways in which we squeeze water out of this washcloth to give our clients some margin of safety in retirement.
What if You Retired in 2008?
Dean Barber: Okay. So you guys have done some research, and you’re going to show us here what you guys were thinking back in ’08. What was the ten-year forward-looking return for a 60/40 portfolio? Where are we today? Let’s begin with that.
David Mitchell: You and I joked before that I don’t think you had people coming in December basically, call it New Year’s of 2009, seeking to retire, that it was still a very uncertain time in the markets.
However, our model at that time of forecasting future returns for a balanced 60/40 portfolio said that over the next ten years, you’re probably going to get around 7.5% a year, which perhaps not coincidentally is about what you got.
David Mitchell: So our model has been pretty successful in the past of forecasting for returns for both stock and bonds. There’s just math involved the longer you lookout.
If you retired, our wealth forecasting toolset in ’08. Looking at Figure 4, if you took out 4% a year adjusted for inflation. You only had a 3% chance of running out of money in 30 years. In actuality, in hindsight, 2009 was a pretty good year to retire for your first ten years.
Dean Barber: Right.
David Mitchell: However, we got to see where we are today, because as this chart’s showing, as markets have been so strong powered by this accommodate of fatty, global, central banks and these other themes you and I have discussed, four returns have continued to go down.
What if You Retired in 2019?
Dean Barber: All right. Now what you’re saying is somebody that retired in 2019.
David Mitchell: So, right before the pandemic hit.
Dean Barber: Right.
David Mitchell: You’re already staring at this because our forward model was saying over the next ten years, 4.5% returns, which means your odds of failure almost go up to 30% if you just kept that at set it and forget it, at 4% a year adjusted for inflation.
Dean Barber: Okay.
David Mitchell: Now we know again, we had the significant drawdown and COVID, we’ve recovered. We’ll see how this lands. But because again, valuations are so expensive now on both stocks and bonds, if I were to show you now the plan failure as of this year, it’s almost at 35%—nearly a one in three chance coming out of the gate that you run out of money.
Dean Barber: Terrifying.
Can Retirees Survive the Next Bear Market?
Last weekend, we did a show on sequence of returns and why it matters and asked them the question, “Can retirees survive the next bear market?” And my comment is, “100% they can. Absolutely, but you can’t do it without a solid plan.”
David Mitchell: Right.
Dean Barber: And the plan has to be that you need some growth, which you have to have an eye on the protection of that portfolio when things get choppy.
David Mitchell: And as you shared, there’re things that we can control and things we can’t. We can’t control how markets are going to perform over the next two years. We can forecast long periods of returns because ultimately, the math is the math, and markets tend to function or be more rational the longer-term out.
The market could be down 20% in the fourth quarter for a black swan reason we don’t see coming. That’s all partly your job is controlling spending patterns, when to pull back, and building in these margins of safety as we go through retirement.
David Mitchell: That’s one of the points that from Alliance Bernstein’s perspective, what we focus on daily, going back to my term, the best offense is a good defense.
Upside, Downside Capture
How can we build client portfolios that structurally can embed ways in which you participate more in the market’s upside than on its downsides? We talk about that. It’s a term called upside, downside capture.
Dean Barber: Right.
David Mitchell: Sounds kind of wonky, but all that means is trying to get as much of the market’s upside as possible but having an eye on the downside.
Dean Barber: All right. So your turquoise line in Figure 6, David, is that’s what we go back to. That was the plan that ran out of money from Figure 3. And this is 60/40 stock to bond?
David Mitchell: 60/40.
Dean Barber: And you’re indexing it?
David Mitchell: You’re indexing it. If you index, that means you get all the market’s upside, 100% of the upside, and you get all this downside.
Dean Barber: Right.
David Mitchell: The point we’re making here, if we just went back and showed different capture ratios, by which you’ll see, the thing you’re looking for is your front number. Your upside is higher than your down. That’s your ratio.
Many people like this 88/74 portfolio. I have found in my conversations, many people say, “If I could get almost 90% of the market’s upside, but only 70%, I think I’d sleep well at night, so keep me invested, too.” That’s the other part, the behavioral science of this: staying invested in the plan.
Defining Success in Your Retirement Plan
Dean Barber: And if you determine your success or the definition of success is you were able to take that income that you wanted to take, keep up with inflation, and not run out of money, that’s success.
David Mitchell: That’s success. I’ll focus on the middle orange line in Figure 6. The other lines, you have a better upside than downside, just again, at the underlying passive level, just for by structurally.
If Alliance Bernstein, if we were able to actively manage portfolios and create what we call alpha. That’s by selecting the best stocks, over average stocks or bad stocks, selecting the best performing bonds versus average or poor performing bonds. That’s called alpha. If we were just to get you a little over 0.5% of alpha a year, look what happens to this plan?
You still get your 88/74. It goes up to about 90/70 when we factor that in it. But you still, you end it with $1 million versus running out of money in year 25.
Catch David on the Podcast
Dean Barber: I think if we can wrap this thing up here, there’s a lot of fascinating information. David and I also got together for a couple of episodes on The Guided Retirement Show™. In episode 17, we talk about economic cycles and avoiding emotional investing. In episode 43, we talk about supercycles and overvalued market conditions. We have a lot more detail on The Guided Retirement Show™, a lot longer. Find it on your favorite podcast app or YouTube.
The Math Doesn’t Work for the Set It and Forget It Plan
Dean Barber: The main thing that I want to say here, David, is that we know market valuations are high. We know that people tend to have that recency bias. We know they tend to think about what’s happened over the last few years, which I think will happen over the next few years.
Your modeling going forward with the 60/40 portfolio being somewhere between 3% and 4% per year over the next ten years doesn’t bode well for somebody who thinks they can take 4%, 5%, or 6% out of their portfolio and still be okay.
David Mitchell: The math doesn’t work.
Dean Barber: It’s going to require more planning. It will require more detail and flexibility, in my opinion.
David Mitchell: It is, it absolutely is. The set it and forget it days are over.
Dean Barber: Thanks for joining us here on the Monthly Economic Update. I appreciate it. Again, check out episode 17 and episode 43 of The Guided Retirement Show™. Thanks for joining us, and as always, stay in contact with your advisor. Let us know if you have questions.
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