The Nothing

One of my favorite movies as a kid was “The NeverEnding Story.” As a nerdy book reader then (and now, for that matter), I could see myself as Bastien as he immersed himself in the land of Fantasia and Atreyu’s quest to defeat The Nothing—the threat to make everything nonexistent.

I recently watched it again and it got me thinking about what some of our advisors are currently dealing with. We are in the eighth year of an equity rally that, aside from a few hiccups, has had minimal declines (markets are supposed to have at least one 20% drawdown every four to five years, and domestically we’ve had zero since the bottom in March 2009).

Looking at the chart below, our average return over the last eight years has been above historical averages, and volatility has been substantially below. At 361 Capital, we are big believers in mean reversion, so our eyebrows are raised a bit with both observations.


Source: Moneychimp.com: CAGR (compounded annual growth rate) with dividends reinvested.

Looking ahead, the expectation for U.S. equities over the next 5-10 years is a real return of about 1.4% annualized, arrived at by averaging publicly available assumptions from GMO, Research Affiliates, BlackRock, JPMorgan, and AQR, along with our own estimates. And for investment grade fixed income, the expectation is for a return of around 0.1% real, again averaging the same firms’ estimates. Even if you take the upper bounds of these estimates, you are looking at perhaps a 3% real return generated from a traditional 60/40 portfolio for the next few years. Yes it is still positive, which is great, but not anywhere near what most advisors and investors have been accustomed to over the majority of their careers, and potentially much lower than some individuals need in order to meet their retirement obligations. Of course, by taking the averages, rather than the upper estimates, you end up with nothing…or maybe The Nothing.

To expand on these numbers a bit, let’s explore the valuation components that go into these capital market assumptions. While P/Es are not at all predictive of near-term returns, they are explanatory over time. Right now P/E levels are in the low 20s. Subsequent 10-year returns at that level typically aren’t off the charts (around 7% nominal, if history is any guide; see the chart below), so it’s highly likely going forward that returns won’t be anywhere near what we’ve become accustomed to—given large cap stocks have averaged 11.5% nominal and 8.5% real in the era of declining interest rates (i.e., 1982-2016).

In addition, as alluded to above, after 30+ years of falling, we are in an incredibly low interest rate environment. Typically YTW is a solid indicator of five-year forward returns and looking at the relationship between interest rates and bond performance—it’s bleak. Even if we do go a bit lower and there is a fraction of return to grab, the risk/reward to that choice is anything but rewarding.

So what do you do when you are staring straight into The Nothing? How can one fight The Nothing?

In the movie, it’s an abstract concept that does not speak, and in the end (spoiler alert) is defeated only when belief and imagination is applied to the problem. Given that context, assuming you’re the type of advisor that does take a forward-looking view when advising clients, which of the three options looks best to you to fight The Nothing?

      • 1. Objective Reality – Some advisors may take the “hard truth” approach and opt to tell clients to be prepared, or begin to change their lifestyle in such a manner to address the future low-return environment. Clients will either have to work longer, save more, or reduce their retirement income outlook and that’s that.

        Since part of an advisor’s job is to set reasonable expectations, you may want to sit down with clients now and look at their portfolios and make sure they won’t need 8%, 6% or even 5% over the next 7-10 years to get where they want to be. And if their plan currently requires such returns, it may be time to make some tough decisions.

      • 2. Risk Hunting – Some advisors may opt to proactively add risk into portfolios in search of returns. Non-U.S. stocks, Emerging Markets, etc. are ways to add potential return, and are some of the more attractive areas of the market right now. The efficient frontier still exists, however, so don’t forget that adding return will also add additional risk—both in terms of volatility and potential loss of capital. Remember, clients at or nearing retirement cannot afford big losses, so contemplate a bucketing strategy or look for other ways to reduce risk. Consider long/short equity as part of a ‘risk budgeting’ approach, which brings us to door number three.
      • 3. The Visionary – Like the hero in our story, these advisors do not settle for the status quo but search for “out of the box” solutions including implementing or increasing exposure to strategies that don’t rely on equity or fixed beta alone to generate returns. Near the beginning of the movie, Atreyu gets mocked for being the ‘solution’ to fighting The Nothing. His fellow citizens of Fantasia laugh because there is just no way in the world he is the answer to their problems. Many might view alternative funds in a negative light due to the incredible historical stock and bond runs of recent years. But if you are like us, and let data, academia and patience shape your decisions, we would encourage you to consider implementing alternatives. Alternatives can help minimize drawdowns, introduce new sources of return and reduce standard deviation as part of a well-diversified portfolio. In real terms, that means more money for your clients on a compounded basis, and it means a smoother experience so they remain invested throughout inevitable market fits and starts.

        We know the last eight years in alts has been difficult (with those kind of standards I imagine everyone stopped investing in equities after the lost decade—I mean why would you own something that returned nothing…for 10 years?!). What we also know is that the last eight years have generated returns that are above historical averages with volatility that is significantly below historical averages…all while interest rates sank as low as Artax did in the Swamp of Sadness.

The picture simply is not rosy on a go-forward basis for most traditional assets, it’s just impossible to predict what that path into nothing is going to look like. There may be large corrections, or there may not be any. We may see muted returns next year, or see strong returns, followed by years of small negative returns. Unfortunately, our crystal ball has been in the shop since we bought it so we can’t predict when this will happen, but we are confident it will. Instead of trying to time it, we urge you to prepare your strategic portfolios for this reality.

Advisors are going to have to make the choice to talk to their clients about minimizing expectations, increasing their risk and/or implementing exposures to different strategies, or perhaps a combination of all the above. The best time to make decisions is when things are going well and you can be thoughtful and strategic (i.e., don’t wait until stress sets in). For ideas on conducting due diligence, check out some resources: Due Diligence Checklist and The New Core Allocation.

For those of you willing to do it, go grab your Auryn necklace and get ready to start your quest against The Nothing!