Market Mediocrity

Last week, Goldman Sachs put out a report that turned many heads.

Goldman market strategist David Kostin authored the report. David is an old friend whom I have known for more than two decades. We collaborated on and debated many market issues back in the day.

In his report, he suggests that in the next decade, the stock market might only see an average +3% return. After taking into account anticipated inflation of +2%, this would mean only a +1% "real" return.

Basically – he argues the stock market will be FLAT for the next 10 years!

This is a BIG change from the last decade, where annual returns have averaged +13% per year.

This is what David said in his report…

“Investors should be prepared for equity returns during the next decade that are toward the lower end of their typical performance distribution,” he writes.

David makes some well-thought-out points.

First, he argues that the stock market's valuation is at historic highs on several measures. This is true.

Historically, from these levels, the forward returns of the S&P 500 are muted. This is a common argument.

Second, he points out that concentration with a handful of large stocks is related to the first point above. Historically, this level of concentration around a small group of expensive stocks has led to future underperformance.

Third, he believes the economy will experience more volatility in the coming years, and corporate profits will fall.

Both are good "mean reversion" arguments. Meaning that if these return to historical averages, they will need to go down.

Finally, they believe that interest rates are likely to be higher than they have been in the last ten years. This would argue for a lower stock market valuation than current levels.

What are our thoughts?

We think David makes some good, sound arguments. This outcome is possible.

Do we, however, think it is “probable”?

His arguments are based on the concept of "mean reversion" we mentioned above. This is the idea that, eventually, metrics return to their long-term averages.

This concept underpins our highly successful trading strategies.

The problem with returning to historical levels is that the world changes.

In the 1980s, most of the largest companies in the S&P 500 were energy companies. These are capital-intensive, highly cyclical, and volatile businesses, and they deserve low multiples.

Compare that to the “The Magnificent Seven” and their business models. These are some of the best businesses in human history. They have much higher margins and better returns.

There is a compelling argument that they DESERVE these higher multiples.

Looking at the gross margins for the S&P 500 companies, we also see that they are 10% higher than historical levels. One argument could be that this is unsustainable.

The other argument is that they are higher because business is much more efficient today than ever before. Before we even think about the impacts of artificial intelligence, think of the incredible increases in productivity we have seen in the last few decades.

The world changes. We are not saying this time is “different,” but we must acknowledge that the world and the economy are evolving. Metrics will evolve with it.

Another part of our view is that Kostin's bet is a very low probability.

Here is a chart from Ben Carlson of A Wealth of Common Sense and Ritholtz Wealth Management…

The chart shows that the S&P 500 annualizes at a +3% return over a 10-year period only 9% of the time.

It IS possible that this happens, but it is improbable. Eventually, we think it will happen, but it is a low-probability bet. Those are not the kinds of bets we like to make.

Our most important takeaway about David's view is that we really don't care!

Our TRADING and INVESTING strategies at HX Research have been created to make money in ANY kind of market. We have demonstrated their success over the last three decades by making money in every major down market.

If you have the right process, you should be able to make money regardless of whether the stock market is +3%, -13%, or +33 %.

Focus on your process, and you will see success.