The year in financial markets has been a wild one. Coming into 2023, few analysts expected equities to outperform, and a banking crisis in the first quarter looked like it might confirm that view. Geopolitical concerns, persistent inflation, higher interest rates and dampening consumer sentiment were also big macro themes throughout this year.
Yet, as year-end approached, equities did surprisingly well despite ongoing macroeconomic turbulence. The S&P 500 was up 8.92% in November, bringing its year-to-date return to 18.97%. Stocks in the so-called Magnificent Seven have soared. One of them—Nvidia—driven by demand for semiconductors capable of powering artificial intelligence, is up approximately 240% this year, according to Reuters data.
If equities maintain their robust performance through the end of the year, stocks will start 2024 looking expensive. Analysts are already noting this in their outlooks for 2024. While strong performance is generally good for portfolios, new research suggests that maintaining this pace of growth could be a tall order in the decade to come and that investors may have more risk in their portfolios than they expect. If equity performance is more in line with historical averages, or if markets weaken, then truly diversifying alternatives are likely to have a significant leg up over passive beta exposures.
A Rally Long in the Tooth
In a recent research note, Jordan Brooks, a principal in and co-head of the macro strategies group at AQR Capital Management, looked at equities performance over the past decade and what it would take to maintain that performance for another 10 years. And while it’s possible equities could keep the rally going for another decade, it doesn’t seem likely. To oversimplify the findings, equities would have to have a 2023 every single year for the next 10 or better.
“We’re coming off a 10-year stretch that, despite a bear market in 2022, has been pretty sensational,” Brooks tells CIO. “So I think it’s a particularly perilous time to extrapolate current portfolio positioning based on the idea that you can repeat that outcome.”
According to Brooks’ findings, over the past decade, the excess-of-cash return on the S&P 500 averaged 11.9% per year. This puts the past decade well above the 90th percentile of rolling 10-year performance across global developed equity markets since 1950. The risk-adjusted return, or Sharpe ratio, of the market over this period, Brooks writes, was 0.82—nearly double the postwar average for global developed equity markets.
Brooks says a combination of high dividend yields, exceptional real earnings growth and high valuations drove returns over this period. The tail wind from valuations alone is in the top third of any 10-year richening period in the U.S. in more than a century, according to his findings. All three components combined contributed to a 10.2% real total return on equities. The findings also showed that low interest rates in the decade contributed an additional 1.7% excess-of-cash return simply by being invested in assets that were keeping up with inflation.
The market conditions that defined the previous 10 years have changed materially. The fed funds rate has gone from near zero to more than 5%. Inflation came roaring back after the pandemic and has only recently shown signs of meaningful decline. Geopolitical uncertainty will likely remain high over the near-to-medium term.
Optimists could look at 2023 and say all of these conditions were true and equities had a banner year. What’s more, if markets get the rate cuts they are already pricing in, that could be a tail wind on performance. Brooks is skeptical of this view.
“The focus on interest rates doesn’t take into account the ability of firms to generate cash flow in the future,” he says. “Over a longer horizon, what matters is the income you get from dividend yield, as well as how much firms grow earnings by and, ultimately, the valuation investors are willing to place on those earnings. If you expect stocks to outperform cash by 12% over the next 10 years, you would need a combination of real earnings growth on par with the best-ever decade, and you’d need to see P/E [price-earnings] ratios well above the tech bubble. Monetary policy doesn’t change that equation.”
Brooks’ math works out this way: According to his note, in the post-World War II era, the average real earnings growth is 2.6%, the 75th percentile is 4.1%, and the 90th percentile is 6.0%. There have been 10-year periods where real earnings growth exceeded 10%, and in those two cases it followed steep declines. The first was post-tech bubble, and the second was post-great financial crisis. Barring a crash next year, equities are not starting from that position. If you use roughly the postwar average and assume 2.5% earnings growth over the next decade, the cyclically adjusted price-to-earnings ratio would need to more than double from its current value of 30 to 61 to post a repeat performance. That would be nearly 40% higher than the tech bubble peak of 44.
Brooks says getting to that kind of performance would require earnings growth at levels unprecedented in a non-recession economy, and the market would have to trade at its richest level ever. It is not an impossible scenario, but it seems unlikely.
Distortion in Index Performance
Even if investors opt for the rosiest view of the future, they may want to evaluate their baseline assumptions. Brooks is not the only one raising flags about performance in equities. A recent note from AllianceBernstein highlighted how the sheer size of the Magnificent Seven companies is affecting index performance.
According to AB, the seven largest stocks in the Russell 1000 Index, which account for about 28% of the large-cap benchmark, surged by 72% this year, through December 12—eclipsing returns for the rest of the market. Similar trends were seen in global markets, such as the MSCI World Index, where the U.S. Mag seven stocks account for 19% of the benchmark. That has changed the style composition of several equity benchmarks.
AB says index providers typically target a balanced split between growth and value stocks in broad market benchmarks. However, since the largest seven stocks are growth stocks, it creates a skew across market capitalizations. Because of the size of the Magnificent Seven companies, the largest 500 companies in the Russell 1000 end up tilted toward growth stocks. And, as a result, the next 500 companies in the index end up heavily skewed toward value stocks—accounting for 73% of the weight in this segment of the market. Meaning when you look across the index, it’s hard to get an even mix of growth and value at each market capitalization. Small- and mid-cap stocks end up reading as value and mega-cap stocks end up reading as growth. The result is a more concentrated and riskier benchmark.
Passive investors could therefore get caught out if there is an abrupt change in market conditions because they would not be as diversified as they expect they are.
Both Brooks and analysts at AB suggest that now might be a good time for investors to take a close look at diversification within their portfolios. While it may be hard for institutional investors to change much if they are not already engaged in an asset-allocation study, Brooks says there are things that can be done on the margin.
“Something is definitely better than nothing,” he says, suggesting that allocations to risk-mitigating strategies, liquid alternatives or global macro could be beneficial to support performance and capital preservation, especially if volatility increases over the near to medium term.
“There’s a real chance that investors are more exposed to equity risk than they fully understand right now,” he says. “We’re looking at a lot of near-term headwinds coupled with the need for exceptional performance to maintain the same long-term performance. To me, that all adds up to a need to think through asset allocation and baseline assumptions.”
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Tags: AllianceBernstein, AQR Capital Management, concentration of risk, Equities, Jordan Brooks, Magnificent Seven, Nvidia, portfolio