Have Stocks Reached Their Limit?
Updated: Mar 29
Pension funds and personal finance gurus often point to the fact that the stock market has produced compounded returns of more than 10 percent since the 1980s and nearly similar returns since the 1930s. Such historic performance is touted as conclusive evidence that anyone who wants to build wealth should invest the majority of their earnings into the stock market, following a buy-and-hold strategy. This, the narrative goes, is the best and perhaps the only way for ordinary Americans to build significant wealth.
Past performance does not guarantee future results
There are at least three major problems with this idea. First, there is the enormous volatility of the stock market. Second, buying into overbought markets can destroy prospective returns. And finally, there are serious long-term issues that the United States as a whole and American business, in particular, are facing. As the SEC mandates many publicly sold companies to succinctly advise their clients: Past performance does not guarantee future results.
Stock investing is great so long as you avoid volatility and never buy into tops
The fact is that today, the stock market is overbought by nearly every objective measure. And it can be shown that, historically, those who bought into market tops, such as those in 1929, 1938, 1967, 1999 and, to a lesser extent, 2008, have had to hold their securities a very long time before realizing any gain at all, much less match the historical 10 percent annual return. In fact, someone who bought into the stock market in 1967 would have had to wait more than 30 years to get close to the market’s historical average returns of 10 percent. Someone who invested in 1929 would be in worse shape still, being forced to wait nearly 60 years to realize those results.
As the economist, John Maynard Keynes said, “We’re all dead in the long run.” For most people, making a significant investment in a market that then suddenly experienced a greater than 30 percent correction would easily constitute what risk analysts sometimes refer to as a mathematical catastrophe. Not only will that person see a huge and immediate paper loss, but they will also lose all of the intervening compounding time that it takes to get back to even.
A full treatment of investing mathematics is beyond the scope of this post. But it is trivial to show that it is not mere average returns that matter: What matters is the total compounded returns. And these are distinct quantities. It is critical to understand that years that produce large losses will produce substandard returns even when the average yearly return is the same.
If you don’t believe this, try it for yourself on an Excel spreadsheet. An investment that is compounded yearly at 15 percent will produce a return of 404 percent after 10 years. Now, pick a string of numbers that represent single-year returns, including years where returns are negative, where the returns have an average of 15 percent. You’ll see that this string of single-year returns will produce significantly less than 404 percent, with many strongly negative years producing significantly lower returns. The reason is that during those negative years the principal actually shrinks, effectively missing compounding opportunities.
Missed compounding is far from the only problem with excessive volatility. The stock market has experienced corrections of more than 25 percent with some degree of regularity. This level of volatility means that great care must be taken when using leverage. It also means that many people may be close to running afoul of a somewhat-unknown but hugely important mathematical principle called the Kelly Criterion. Without delving into the complexities, this effectively means that people who take on too much risk within a portfolio may be accepting a risk of ruin that can actually turn an otherwise positive-returning investment into one with a long-term expected loss.
Changes to America’s business climate
The other serious long-term problem with expecting the stock market to continue posting returns that align with historically derived expectations is that the country’s business environment is rapidly changing due to a number of distinct but interrelated factors.
Mass immigration, primarily from countries with vastly lower per-capita GDPs than America's, is rapidly changing the demographics of the American workforce. At its core, the U.S. stock market is simply a reflection of the total productive capacity of American business. An American workforce that declines to productivity levels that are more aligned with second- or third-world countries will eventually cause the stock prices of businesses to reflect that new reality.
There are starry-eyed optimists who claim by citing what reduces to one form of magic or another that iron demographic laws can somehow be suspended and a lower-productivity America avoided. However, the sad reality is that these assertions are utterly contravened by nearly every piece of empirical data available. As a result, the future of American business will be more like Mexico than Macau.
Offshoring, loss of institutional knowledge and the rapid ascent of China as a formidable industrial competitor are all additional factors that strongly indicate that the American Century was indeed the prior one.
Investing in real estate will make far more sense going forward
To many, commercial real estate investing currently seems duller and less sophisticated than investing in other asset classes. But in the coming decades, it is likely that real estate will come to be known as the new form of smart investing.
One of the things that make real estate a great vehicle for smart investing is the fact that it is understandable in a way that stock investing as a whole is not. Investing in real estate also tends to be dramatically less volatile. As the macroeconomic situation itself becomes more volatile and consequently difficult to predict, the more easily understood economics of local housing and industrial real estate markets will make those investments far more attractive.
At the same time, the lower volatility of real estate means that leverage can be used with far greater safety and, ultimately, with a much more potent effect. This is especially true for those who take the time to become experts in their local markets.
Commercial real estate investing creates predictable cash flows that are unlikely to seriously decline. The reason is that every person needs a place to live and every business needs a place to conduct its operations. This tends to put a hard floor on how low demand for commercial real estate can fall.
With steady cash flows, intelligent investors can make use of leverage to boost internal rates of return far higher than the nominal return on commercial property may indicate. Using any kind of leveraged strategy in the stock market is inherently risky, at times to the extent that it violates the above-mentioned Kelly Criterion, creating expected losses even where the underlying investments are known to produce positive returns. And this often intolerably high level of leverage risk is due to the stock market’s unpredictable and nearly infinite-variate nature.
However, for the astute and sophisticated commercial real estate investor, building a highly accurate model of how a commercial property economically performs is well within achievability. When all risks are accurately quantified, the smart use of leverage can dramatically increase internal rates of return, potentially leading to annualized returns that can rival some of the greatest investors of all time.
Equities aren’t what they used to be
Stocks may not have reached their limit. In nominal terms, they have probably not even begun their rise. However, this does not mean that other asset classes will not prove to be much better choices in the future.
It is likely, however, that the U.S. stock market has long since passed its inflation-adjusted zenith for yearly compounded returns. Fundamental changes to the country, including the near inevitability of the dollar losing reserve currency status, a large per-capita productivity decline and a relative slide versus America’s global competitors, all mean that less-volatile and more readily analyzable assets are where the smart money is likely to go. And none fits this description better than commercial real estate.