Ten more years of low returns in the stock market.  If you are one of the millions of baby boomers headed into retirement - start saving more and spending less because the stock market won't bail you out.  Now that I have your attention I will explain why this is the likely future ahead for investors. 

In this past weekend's newsletter I wrote that “If you put all of your money into cash today and don’t look at the market for another decade – you will be better off..."  I realize that this statement is equivalent to heresy where Wall Street is concerned but there is one simple reason behind my apparent madness - the power of "reversion".

This is not a new concept by any means as witnessed by Bob Farrell's rule #1 - "Markets tend to return to the mean over time."  However, the reality of what "reversion" means is grossly misunderstood by Wall Street, and the mainstream media, as witnessed by the many valuation calls that "stocks are now cheap because the market is now trading in line with its long term average."

The power of "reversion" is much more than just returning back to the average (or mean) price level over time.  In reality the movement is far greater.  Let me explain it this way.  If you take a rubber band and stretch it as far as you can in one direction and release it - the band does not return back to its original starting point.  What you will find is that the band will "revert" approximately an equal distance in the opposite direction before returning back to its starting point.  Stock prices and valuations are very similar in this regard as highlighted in Bob Farrell's rule #2; "Excesses in one direction will lead to excesses in the opposite direction." 

In the first chart I have plotted the S&P 500 index on an inflation adjusted basis compared to its long term growth trend.  The area chart below is the most critical to this analysis as it shows the deviation above and below the long term growth trend.  Since 1900, when the market has attained excesses in one direction the reversion process has never, and I repeat never, retraced back only to the long term growth trend before starting a new cycle.  Yet, this is exactly what Wall Street are telling you will happen. 

In the past 112 years each and every reversion process has traveled roughly an "equal distance in the opposite direction" much like the rubber band.  When the market has risen 50% above the long term growth trend subsequent market performance fell markedly until the reversion process was complete.  In almost every case a 50% upside deviation ultimately led to a deviation of 50% to the downside.  As my friend Doug Short eloquently stated:  "About the only certainty in the stock market is that, over the long haul, over performance turns into under performance and vice versa."  Unfortunately, for baby boomers rapidly approaching retirement, the reversion process that is currently underway still has further to progress which means future stock market returns are unlikely to shore up any shortfall in savings. 

The Reversion Of Earnings

What will drive the continued reversion process.  It will be the next recession which will drive a reversion of earnings.  While Wall Street analysts currently have earnings growth forecasted to rise indefinitely into the future - the reality is that earnings cannot out grow the economy for very long.  The companies within the S&P 500 are a reflection of the economy and not the other way around.  Therefore, if the economy is growing at a sub-par rate then corporate earnings cannot continue to post substantial earnings growth into the future.

In our post "Corporate Profits Are In Trouble"we wrote:  "Don't count on an 8% annualized return going forward to plan for your  investments.  The math tells you otherwise.  Since 1947 GDP has grown 6.6% annually, EPS has grown at 6.7% annually and the average growth of the S&P index itself has grown at 6.6% (not including dividends).   Going forward if the economy is slated to grow at an annual rate of 4%, as hoped by the current slate of economists and Wall Street analysts, then it is going to be difficult to crank out 8% returns in portfolios for retirees hoping to get away with under saving for their retirement.

However, If the next decade of a debt laden economy burdened by high unemployment, higher rates of inflation and lower wages, then economic growth may be more aligned to grow at a mere 2-3%.   If you Include a current dividend yield of 2% plus 2-3% growth in the markets on an annualized basis; it becomes very difficult to navigate through retirement particularly if you were underfunded to began with."

The chart of S&P 500 earnings shows the long term growth trend of earnings.  The reversion cycle in earnings, like the price, is quite apparent.  While the price of the stock market has ranged between a +/- 50% deviation of the long term growth trend line; earnings have swung between a 6% peak-to-peak and 5% trough-to-trough growth rate.  With index earnings currently heading towards the peak of the current cyclical earnings cycle there has already been a marked slow down of year-over-year growth rates.  The phenomenal earnings growth posted from the 2009 recessionary lows was exceptionally strong but unsustainable as earnings have now caught up with the sub-par economic growth rate. 

I have plotted out a projected normal reversion of earnings which would currently push earnings per share back towards $60 a share.  Over time the trough-to-trough growth trend will rise but the reversion process, when it occurs, will be very similar to every other previous reversion in the past.  Depending on future Fed market intervention the reversion process in earnings will lead the next economic recession.  That recession is likely to occur late 2012 to mid-2013 sans further stimulus.  Earnings reversions have typically always been followed by the onset of a recession.  (Note: The financial crisis of 2008 took the reversion process well beyond norms but that was also a monstrously abnormal event.)

A Reversion of The "P" And The "E" = P/E Reversion

Are stocks cheap?  The media valuation argument, as discussed, is consistently "based on forward earnings expectations".  There are two primary problems with this argument.  The first is that when valuations are discussed the current level is ALWAYS compared to reported trailing earnings not estimates.  Using forward estimates to make a valuation argument is comparing apples to oranges and reeks of poor analysis.  Secondly, since forward estimates are historically over estimated by as much as 30% - using inflated forward estimates, which are subject to downward revisions, consistently skews the argument.  For example, let's examine the 1st quarter of 2012.  Valuation arguments in October of 2011 were based on an assumption of 10% earnings growth.  Today that growth rate has been revised down to less than 1%.  At the same time market prices have surged in the first quarter driving valuations higher.  What was "cheap" in October is "expensive"  today.

Furthermore, when arguments are based on improving future valuation metrics, it won't be because earnings are improving faster than the price of the market.  These two components are not detached from one another and the "reversion" process will improve valuations by dragging both the "P" and the "E" lower.

The chart shows P/E valuations using Shiller's trailing reported 10-year smoothed earnings model.  As you will immediately notice the deviation chart looks very similar to the deviation chart of the price of the index.  Valuations, like the price, are well entrenched in the long term reversion process.  With valuations still well above the long term median the real question is whether or not you will survive the reversion process.

10 Years And Loving It

If we look at the reversion process as a whole we can see that the process requires time, a lot of time, to complete.  Currently, we are already 12 years into the current reversion grind and it has not been kind to investors trying to save for retirement.  Assuming that we are in a "normal" reversion process then theoretically we should only have about 5 to 6 years left to complete a normal cycle.  However, given that the current cycle is anything but normal, the reality is that the process most likely has much longer to go.

This got me to thinking about the things we need to consider, as investors, when thinking about saving for retirement and managing portfolio risks.  Here is a list of things to consider.  

1. "Buy and Hold" investing will not work.   Active management to participate in cyclical upswings, and avoid the majority of downswings, will be key.
2. "Save More & Spend Less."  Savings will make a large chunk of your total retirement nest egg.  This has always been the case.
3. "Lump Sum Invest Vs. Dollar Cost Averaging."  Accumulate cash and invest in lump sums when things have become undervalued during the cyclical bear markets.  This will provide better returns over time especially when combined with an active management strategy.
4. "Income Over Growth."  The income theme will continue to dominate investor psychology particularly in the baby boomer generation.
5. "The Inflation Benchmark."  The real benchmark for investors to focus on is inflation - not an index.  Inflation, except in rare instances, actually compounds annually - stock markets don't.  Managing portfolios to limit losses and pace inflation will be key to ensure future purchasing power parity. 
6. "Diversification."  Real diversification between non-corollary assets will be key in the future to hedge off market volatility and reduce emotional mistakes.
7. "Real Assets."  Investing in physical real assets such as income producing properties, oil and gas wells, precious metals, private equity, etc. will perform better in a rising inflationary environment.  The key here is having a "real asset" behind the investment that will retain value even in deflating market environments.
8. "Fixed Income"  Even in a rising interest rate environment actual fixed income, not bond funds, will provide income, low volatility and principal protection to portfolios.  Short duration ladders that can ratchet up as interest rates rise will provide portfolios with an edge over long only equity portfolios

Of course, there are many other investments that will do well and these are just a few ideas to start the thinking process.  Furthermore, there will be fantastic and tradable bull market rallies like we have seen twice so far this century.  Being able to capitalize on those rallies will be critical in offsetting the rate of inflation and creating portfolio returns.  Unfortunately, the ensuing declines will also destroy all the gains and then some so being vigilant and disciplined in your risk management process will be critical. 

However, the most important asset destroyed by reversion processes is "time".  It is the one commodity that you have a very limited supply of and no ability to replace.  Reversion doesn't mean that the markets "crash", although they certainly can, but the slow grind through the process will be like "Chinese water torture" for investors slowly destroying valuable assets over time.  Understanding the environment that we are in today, and will continue to face going forward, can help us make better decisions in both our planning and investment process.  Ignore the reversion process at your own risk.