If investors truly believe that “this time it’s different,” they need to understand that they are betting against almost 200 years of market performance, says Jim O’Shaughnessy, the Connecticut-based star fund manager renowned for his quantitative investment philosophy.
O’Shaughnessy, chairman and CEO of O’Shaughnessy Asset Management, who manages a number of popular mandates for RBC Asset Management, lets the numbers dictate his investment strategy. He points out that, in more than 100 years of U.S. market data, long-term stock market returns always come back to their mean, an annualized compounded 7% real rate of return.
If historical numbers are a reliable guide, as things have gotten worse, market prospects have drastically improved.
“The challenge we have as investors is to take the behavioural aspect of people into consideration. Everyone I’ve talked to — and I talk to a lot people — is terrified; they have the inability to unstick themselves from what has recently happened, and have the inability to recognize that a) this has happened in the past and b) we are not unique in our situation,” O’Shaughnessy says. “Human beings buy securities. Things move in and out of fashion. There is a business cycle, and you cannot repeal that business cycle.”
O’Shaughnessy says recent research into the 19th century shows the same pattern: regardless of global economic circumstances, business cycles and therefore stock returns drive back toward the same mean.
As cycles go, the early part of this one has been the worst in history, he says, meaning the prospects for the next 11 years of investing seem very appealing. Even if the stock market were to have a healthy compounding real rate of return of 6%, this rolling 20-year period of stock returns would still finish off as the worst in history.
“What I found is if the stock market beginning this year starts to compound at 6% real rate of return through December of 2019, the 20-year annualized real rate of return would be 0.19%, ten basis points lower than the lowest 20-year period ever recorded, which ended in 1949,” he says. “I do not believe the current economic circumstances warrant that type of conclusion.”
He adds, “If you look back to the early 1930s, the United States had 25% unemployment, GDP declined by 33%, and land values were cut in half. The Federal Reserve contracted the money supply by 80%. Clearly, none of those are present. Yes, GDP will slip, unemployment may get to 10%, but the Fed, far from contracting, is expanding and is serving as the lender of last resort.”
As a man who will let only math dictate his investment decisions, deduction then suggests that a 6% return is the baseline prediction for the next 11 years of stock returns.
Given that economic conditions don’t seem as dire as they were in the Great Depression, he says it wouldn’t be unreasonable to expect double-digit returns.
Few investors share this unbridled optimism right now — it feels different for them — but O’Shaughnessy has maintained for years that they were spoiled over the last 20-year rolling cycle of returns that ended in 2000, which were the best in history.
“In March of 2000, there was nary a negative story on the market anywhere. Everyone felt like an heir to a glittering throne. The U.S. had a surplus; it had destroyed the USSR, the biggest superpower in the world. Everyone thought their birthrights were returns of 15% to 20%,” he says. “There are 200 years of data suggesting that in fact what happened is that the market reverted down to its mean. If you invested a dollar in the S&P 500 in 2000, when you strip inflation away, it is worth 50 cents today.”
At the turn of the millennium, O’Shaughnessy was ridiculed in some corners for predicting 3% to 4% annualized returns for the coming years. Ironically, this prediction ended up being overly optimistic. O’Shaughnessy concedes that even he didn’t anticipate the eventual carnage of this decade, but this only strengthens his conviction that things will get better.
“Back at the turn of the century, we were forecasting 3% to 4% annualized returns and everyone thought we were barking mad because they were expecting 15%,” he says. “Well, if you compounded at a 12% real rate of return from now until the end of 2019, you’d still only turn in a real rate of return of 3.3%. From our perspective, because of the damage happening so early in the game, we expect the market will certainly deliver 6% and 12%.
Even more interesting are the short-term prospects for the markets, O’Shaughnessy notes, because historically the returns on stocks have realized phenomenal gains not too long after a devastating correction. In examining the 12 worst periods of ten-year returns, O’Shaughnessy says they were always followed by years with positive returns.
On average, the year after one of those worst-12 periods, returns were 25.8% for that year. After three years, returns compounded annually at 11.46%, five years later they compounded at 13.49% and finally ten years later they compounded at 10.75%,” he says. “We have beta back to 1900 on U.S. stocks, on an annual basis. When you look back to 1900, there were only three decades that provided negative returns to investors. The first decade was 1910 through 1919, the second decade was 1970 to 1979 and, barring a miraculous 100% to 200% rally this year, the [third is the] decade of 2000 to 2009.”
Of course, each of those preceding two periods were followed by historically strong bull markets: the Roaring Twenties and the 1980s.
Not surprisingly, O’Shaughnessy is loading up on equities.
“I don’t often say this, but this is buy-everything time,” he says. “We do think the prospects for a couple of strategies are superior. One area is large cap growth stocks, since they have been down 70% in the last nine years. Another area is small cap value. We think that, given the hit that small cap value took in the last quarter in 2008. Small cap value has been the best asset class bar none and our expectation is you’ll see that coming back strongly.”
He remains very upbeat on quality dividend stocks.
“These dividend stocks are a godsend to conservative investors. We are buying stocks on their dividend yields, making certain they are market-leading companies. We define a market-leading company as having a market cap, shares outstanding and cash flow all greater than average. In addition, these companies have sales or revenues greater than 50% [more] than average. If you apply that criteria to companies in a universe that holds about 8000 names, that gets you down to about 340 names.”