There is Always Something to Worry About

Interest rate changes have continued to support relentlessly strong US dollar moves against European currencies.  Republicans and Democrats continue to debate the best way to address the nations aging infrastructure problems.  A massive hurricane recently caused deaths and severe damage to parts of Florida.  There is growing concern that Moscow may attempt to restore something like the old communist regime.  These events, among others, have left Time magazine to ponder “is there light at the end of the tunnel” for the economy.  The date is September 28, 1992:

September 28, 2022

At 6AM on my commute to the office the news headlines were worrisome:

·        A borderline category 5 hurricane (Ian) will shortly make landfall in Florida

·        Russia annexed parts of the Ukraine

·        A series of explosions took out parts of key gas transportation pipelines (Nord Stream) into Europe

·        North Korea fired a missile directly over Japan, ahead of the US VP trip.

·        The US Dollar Index rose to the strongest level since 2002.  The Japanese yen and the British Pound Sterling were at their weakest Vs. the US Dollar since 1990 and 1970, respectively.

·        The yield on UK Gilts (bonds) reached 5.14%, the highest since 1998, and up from 1.17% since the beginning of 2022

·        The yield on the 10-year US Treasury crossed 4%, the highest since 2008

·        Finland wants to build a fence on the Russian border

·        The Dominican Republic wants to build a wall on the Haitian border

The fear was palpable.  There is certainly plenty to worry about globally, just as there was thirty years ago.  The S&P 500 Index would finish the day 1.97% higher.  However, it would end the week 2.89% lower, and down 21% year-to-date.

A Thirty Year Look Back

The following chart shows the S&P 500 Index over the past thirty years ending on 9/28/2022:

·        The red shaded areas are US recessions

·        The solid blue line is the 10-YR US Treasury Yield (right Y Axis)

·        The dashed blue line is the median of the 10-YR US Treasury Yield

This thirty-year period includes the tech bubble crash, 9/11, wars, the great financial crisis, a once in a hundred-year superstorm, and a once in a hundred-year pandemic, among other events.  Over the period the S&P 500 Index has increased 1506%, or 9.7% per-year for thirty years.  The median 10-year US Treasury yield during this entire period was 3.8%.  On September 28, 2022, the 10-Year Treasury yield was 3.7%.  Over the entire period S&P 500 equity investors earned an annual return 5.9% higher than the median treasury yield. 

We thought it would be interesting to look at the compound annual returns that investors earned over different time periods, during the thirty-year period.  The returns follow:

The annual return rates are strong, even measured after the recent decline in the index.  For perspective, consider that the annual return in 5 of the 6 periods is superior to the return earned from investments in the ITHP. 

The Equity Risk Premium

Over time investors expect to earn a return over and above the return available on a risk-free asset.  The risk-free asset is US Treasuries, and we prefer to use the 10-year.  Think of it this way, if you can earn 3.7% risk-free on a government bond, then other investments have to offer higher expected returns to attract investors.  In our experience a reasonable range is generally considered to be 4-6% above the 10-year treasury yield.  Ultimately, the risk premium that market participants require impacts the pricing of securities.  Higher (lower) premiums equal lower (higher) securities prices.  A simple framework that uses today’s 10-year yield of 3.7% as the risk-free rate, and an equity risk premium of 4-6% above the risk-free rate, would expect S&P 500 Index returns of 7.7%-9.7% per year for the next 10 years.

 The incremental earned annual returns in the 5–30-year periods above are the investors realized reward for bearing the risk (volatility) of investing in the stock index.

Conclusion

There are plenty of market and geopolitical risks to worry about, just like there were thirty years ago.  Despite these risks, Investors managed to do well over the past thirty years and earned strong stock market returns.  These market returns were superior to ITHP returns in 5 of the 6 time periods we analyzed, albeit it with much more volatility.  We don’t know what future market returns will be, it is unknowable.  However, in our opinion the simple framework we presented is a reasonable expectation over the medium to long-term.  In the short-term the market could do anything.

There are many considerations beyond expected returns.  For example, investors should consider time horizon, taxes, liquidity needs, and risk management strategies that could protect them in case the current pullback becomes a severe drawdown.