By Roman Chuyan, CFA

A View on Stocks and Commodities

  • In this year-end note, I offer a longer-term perspective on US stocks over the past two decades, and what to expect in the 2020’s.
  • Our 7-year model forecasts low return for stocks, and we think commodities will outperform.

The pandemic left a dark mark on last year, with illness, loss of life, a recession, and massive unemployment. But it was another good year for investors. The S&P 500 fully recovered from a 35% peak-to-trough plunge in March when the pandemic hit and finished the year up 18.4% (including dividends).

As we are closing not only the year but also the 2011-2020 decade, I offer a longer-term perspective in this note. What drove stock returns in the past decade, and is it likely to continue in the 2020’s?

Let’s compare the past two decades:

Compounded annual total return on S&P 500,
Compounded annual nominal GDP growth.

The stock market gained a remarkable 13.8% annually in the 2010’s (264% cumulative), almost ten times its annualized gain in the 2000’s. At the same time, nominal GDP growth was similar in the 2010’s (3.9%) to the 2000’s (3.3%). The two recessions of the 2000’s hurt stocks more than they hurt the economy, but stock return was nonetheless close to economic growth. In the 2010’s, stocks became disconnected from the economy.

Stocks, GDP, and the Fed, 10 Years

Source: Ycharts, as of 12/31/2020

You’ve probably guessed where I’m going with this. The Fed drove the returns in the 2010’s much more than the economy did – specifically, the Fed’s money-creating policies. As shown in the chart above, the Fed tripled the assets on its balance sheet (the yellow line) in the 2010’s, to now $7.4 trillion. The S&P 500 followed the Fed’s balance sheet rather than GDP (the light-blue line) – it also tripled in the same period (excluding dividends).

To get a sense of what to expect from the market going forward, we at Model Capital use forecasting models. To look far ahead, we use our 7-year model for the S&P 500. Keep in mind that a 7-year horizon is too long for tactical investing – the market can change many times in seven years. But it gives a useful long-term perspective, and I sometimes write about it at year-end.

According to our research, the best single factor that determines 7-year market returns is the total allocation to stocks by all investors (blue bars on the chart above, scaled with the left Y axis). This is the total percentage of portfolios that all individual and institutional investors, in aggregate, have invested in stocks and stock funds. When this allocation is low (there’s room to buy more), subsequent 7-year return (the green line, right Y axis) tends to be higher, often above 10% annually. On the other hand, when stock allocation is already high (no room to buy), subsequent 7-year return tends to be lower, often near zero. Stock allocation dropped below 30% after the bear market ended in 2009, and subsequent 7-year returns were above 10% annually from 2009 to 2013. (The green line doesn’t go any further because 2013 is the latest year for which the subsequent 7-year return is available, 2014-2020.)

Our model’s 7-year return forecasts based on this and other factors are shown by the dark-red line. The forecast tells us what 7-year return we should expect going forward, given the total stock allocations (and other factors) at the time. The forecasts (the red line) track actual returns closely, which suggests that the model has been reasonably accurate.

The current stock allocation (the right-most blue bar), at 46.4%, is near its highest since data began in 1950. It matches the allocation on 12/31/2019 (which preceded the Feb-Mar 2020 plunge) and was exceeded only during the dot-com bubble in the late-1990’s (which was eventually followed by the 2001-02 bear market). This suggests that investors are fully invested in stocks right now and there’s no room to buy more. The model’s current 7-year forecast is only 1.6% annually.

Return expectation is very important for strategic asset allocators. Strategists expect stocks to continue to deliver a 10% or higher annual return. If such a low return is realized instead, most pension funds will not achieve their targets. For tactical managers like us who attempt to manage “the ride,” a 7-year annual return forecast of 1.6% suggests an environment similar to the 2000’s when average annual return was 1.4%, as I detailed at the beginning. That decade included two severe bear markets, in 2001-02 and 2007-09 (the left half of the 20-year chart below), which made the overall return in that period so low. This is a type of market environment we expect in the coming years – rallies giving way to declines, and a low overall return.

Stocks and Commodities, 20 Years

What if the Fed keeps creating money? The Fed brought interest rates to zero and roughly doubled its assets to $7.4 trillion in 2020, by buying bonds, creating trillions of dollars of new money (the Fed buying anything by definition amounts to creating new money). Money-creation certainly looks to continue, with a return to prudent monetary policy looking more and more unlikely. With pandemic crisis last year, any opposition to these policies from fiscally-conservative Republicans was rendered unpopular. A return to prudent policies just became even more unlikely this month, with Democrats gaining control of the Senate in addition to the presidency and the House of Representatives.

But it might not lift stock return significantly above 1.6%, and significant downturns are still likely to happen, as they did in 2018 and in 2020. Money-creation made most assets very expensive over the past 10 years – stocks, bonds, and real estate – but not commodities. The Commodity Research Bureau’s (CRB) index outperformed stocks in the 2000’s but dropped by 46% in the 2010’s (see chart above). This left commodities the only asset type that’s not extremely overvalued, and it might reverse in the coming years as relative valuation evens out, especially if money-creation continues.

About Model Capital Management LLC

Model Capital Management LLC (“MCM”) is an independent SEC-registered investment advisor, and is based in Wellesley, Massachusetts. Utilizing its fundamental, forward-looking approach to asset allocation, MCM provides asset management services that help other advisors implement its dynamic investment strategies designed to reduce significant downside risk. MCM is available to advisors on AssetMark, Envestnet, SMArtX, and other SMA/UMA platforms, but is not affiliated with those firms.

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