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ACM Journal - Investment Management
15 Oct

A Sober Look Ahead – Q3 2021 Newsletter

Despite a weak September, the stock market has generally fared well of late. Returns have been strong year-to-date, and over pretty much any trailing period. There have certainly been bumps in the road, such as the COVID correction in March of 2020, but the last major disruption was thirteen years ago in 2008. While rising stocks are generally good, there can be too much of a good thing. We may be getting to that point, and the same may be true for the bond market.

The problem with stocks rising too much is that they start to become expensive. For example, a stock that trades at 15 times its annual earnings appears attractive relative to the range of where stocks have generally traded in the past. An attractive valuation today means there is still room for that stock to appreciate in the future. On the other hand, a stock that trades at a high valuation today, such as Tesla with a price/earnings ratio of 426 times earnings, may have limited upside in the future.

The bottom line is that low prices today generally lead to higher returns in the future, and high prices today generally lead to low future returns. The relationship is not as clear as we would like and trying to time the cycles of market ups and downs based on this logic is all but impossible. Nevertheless, it has played out on average and over time.

This relationship of current prices to future returns is fairly universally recognized in the investment world, leading many to question future stock market return potential. The table below shows forecasts for various components of the stock market looking forward 7 to 15 years. We assembled these forecasts from investment firms that we deem to be superior research shops and/or highly credible sources. There is a range of possibilities, but the main point is that all of the forecasts are well below long-term averages for every part of the capital markets. Returns in the future are expected to be much lower than what we have enjoyed in the past.


That said, overvaluation in the stock market is rarely the trigger for bear markets. Usually there is some other issue that suddenly changes the economic landscape or market sentiment. Today there are a host of such issues, including the threat of rising interest rates, higher inflation, likely lower corporate earnings, and exogenous events such as geopolitical tensions.


Rising Interest Rates

Interest rates directly impact the returns of the bond market. As rates rise, bond prices fall. We’ve been in a 40-year period of falling interest rates, making bond investments quite profitable. However, with rates now at uber low levels, we may be entering a long-term cycle of rising rates.

Rising interest rates are not only bad for bonds, but also for stock investors. Many stock valuation models include interest rates as the discount rate for corporate earnings. So, as interest rates rise, valuations decline. More practically, higher rates mean higher borrowing costs for corporations, making it more expensive for them to invest and grow. So, rising interest rates could present a problem across the capital markets.

The Fed has kept short-term interest rates low for some time but may be ready to hike rates as early as next year. Market forces set longer-term rates, and they have been rising lately, albeit from very low levels. An increase in inflation could also result in interest rates that continue to rise.


Inflation has been tame for decades. It really has not been a problem for investors since the 1980s. However, prices have been rising lately, and not just in a few areas. Energy prices are up, which impacts transportation costs, which results in a general rise in the price of finished goods. Because prices are up, employees need to earn more, so wages rise, and the cycle feeds on itself. The Fed has assured us that inflation will be transitory, but so far it has been higher and lasted longer than anticipated, and it appears to be a global phenomenon. Until supply and demand come into balance, inflation is a risk, and unprecedented global liquidity combined with labor and material shortages don’t bode well for that balance.


Corporate Earnings

Corporate earnings have remained surprisingly resilient during COVID, and profit margins remain at high levels, thus supporting relatively high valuations within the stock market. However, proposals for higher corporate tax rates and increased regulation, as well as inflated input costs, could weigh on earnings and margins in the future. So far these proposals have not become law, and it is not clear they will be enacted, but there does seem to be a movement toward reigning in corporate behavior through both legislation and the courts.

Exogenous Threats

Other issues that could derail the stock market include a slowdown in China, a government shutdown in the U.S. as we once again face the debt ceiling in December, renewed terrorism, a global energy shortage, a slowdown in global growth as we work off unprecedented government debt, and countless others. Reading the news these days is almost sure to cause extreme depression. There are so many issues in so many parts of the world, that any one of them could become a significant threat to our safety, economy, and markets. This of course has been true many times throughout history, so we caution about becoming overly

concerned, but certainly these issues bear watching.

A Silver Lining

On a more upbeat note, there are actions we can take to address economic uncertainty. Diversification, which has been a liability the past ten years as large-cap tech stocks dominated the market, should offer higher returns and a smoother ride in the years ahead. Valuations for small-cap stocks, international stocks, and particularly “value” oriented stocks are much lower than those of the overall U.S. stock market and could provide stronger future returns. Similarly, alternative investments seem poised for better days ahead. Many of these strategies have lower correlation to the stock and bond markets, which should help them generate returns regardless of how traditional investments perform.

While the outlook for stocks and bonds is not rosy, it doesn’t imply that investors should sell out and hunker down. First off, the erosion of purchasing power from inflation can be just as damaging as actual market losses, so cash is a poor choice these days. Second, it can be expensive to sell out of investments if there will be capital gains taxes to pay. Finally, it is possible that the stock market continues to rally for far longer than seems possible or rational. Markets certainly move in mysterious ways, and interest rates could conceivably drop further. Rather, the better approach is to stick with a diversified, long-term asset allocation plan but reset expectations since past is unlikely to be prologue as we look out over the coming 5-10 years.

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