Yogi Berra famously said, “It is tough to make predictions, especially about the future.” We strongly concur. Yet “expert forecasters” continue to make economic and market prognostications about the coming year despite the fact that human experts are worse than rats at such predictions and that these experts have demonstrated zero success in forecasting the stock market or the economy. And we continue giving them the stage to do so because human braves are wired to detest the chaos of an uncertain future. Even if prognostications do not provide any clarity at all, they satisfy our brains with the false perception of clarity. Our brains are wired to what behavioral economist Jason Zweig labels “the prediction addiction”.

To quell the itch for 2021 market predictions, I offer two of my annual favorites from authors Barry Rithlotz and Jonathan Clements. Their predictions about the upcoming year are likely to be more accurate than 99% of the alternative forecasts. Moreover, we offer below our 10 financial predictions about the next decade. Making predictions about the next 10 years is admittedly far less exciting or glamorous than predicting what sectors will outperform in 2021 or what stocks to buy in 2021 but it is a far more reasonable undertaking. And – speaking from a point of sincere humility – it will require more time to be proven wrong.

1) Value stocks will outperform growth stocks by at least 1.5% annually.

Between 1926 and the end of 2019, US value stocks outpaced their growth stock kin by an average of 4.4% per calendar year. However, the past decade has witnessed a sharp disconnect from this tendency with growth stocks besting value stocks in 6 of the prior 7 years. Growth stocks have become – as a result – dramatically more expensive relative to value stocks than at any point in history – including the historic dot-com boom of the late 1990’s. As we explained in this recent post, the single most important phenomenon in the stock market right now is this unprecedented value/growth relationship that sets up very well for value stocks going forward.

Measurement: Russell 1000 Value Index vs. Russell 1000 Growth Index 

2) Developed foreign stocks will outperform US stocks by at least 1% annually.

The case for this forecast is driven by the dramatic valuation gap between foreign stocks and domestic stocks. US stocks, in aggregate, are expensive by nearly every valuation metric whereas foreign stocks offer much more attractive valuations. If the relationship between the two reverts towards historic averages, we would expect foreign stocks to outperform US stocks by 2%-6% per year over the coming decade.

Measurement: MSCI EAFE Index vs. S&P 500 Index

3) Emerging market stocks will outperform US stocks by at least 1% annually.

There is a compelling case to be made for emerging markets over the next 25 years based strictly on demographics with a faster growing and younger population to counter the developed world’s graying population. Demographics have historically played an important role in stock market returns over extended time periods. However, we can ignore the demographics case and focus strictly on the valuations where depressed emerging market valuations set the stage for outsized returns over the coming decade.

Measurement: MSCI Emerging Markets Index vs. S&P 500 Index

4) US stocks earn a nominal return of less than 6.0% per year

Many long-term forecasts for the US stock market that use a quantitative framework would look at 6.0% per year over the next ten years as extremely optimistic. Morningstar calculates an expected annual return of 1.7%. Research Affiliates estimates a 0.3% annual real return while Vanguard estimates a nominal range of 3.5% – 5.5%. The foreboding problem for US stocks is they they are extremely expensive based on almost every measurement. Using the popular price/earnings ratio, the S&P 500 is more than double its historic average. Using a better predictive measure – the cyclically adjusted price/earnings ratio – US stocks trade at nearly 2.3 standard deviations above their long term mean. 

Even if US stocks don’t revert to historic averages but just maintain these rich levels for the next 10 years, the case for returns approaching 6% per year would depend largely on inflation running at 4% or more over that stretch – definitely not something that retirees should be hoping for.

Measurement: S&P 500 annualized total return

5) US bonds earn a nominal return of less than 2.0% per year

The 10-year Treasury yield dropped below 1.0% in March 2020 and has not eclipsed that level since. Although non-government high grade bonds (corporates, mortgage backed securities, etc.) may have higher yields, the expected long-term return for such bonds tends to converge closer to Treasuries as downgrades, defaults, and other credit events impact long-term results. As a result (and as evidenced by the chart below), the current 10-year Treasury yield provides an extremely useful way to forecast the 10-year forward return for bonds. Based on current yields and the mathematical ceiling imposed on bond returns by these yields, it is hard to envision a scenario (aside from the one where interest rates went sharply negative) where the total annualized return for US bonds exceeds 1.5% – 2.0% over the next decade.

Measurement: Bloomberg Barclays Aggregate Bond Index Total Annualized Return

6) Cash produces a negative real return

The Federal Reserve has publicized its playbook: an expectation to keep short-term interest rates near zero through at least 2023 and the scrapping of historic policy to promptly raise rates in response to a drop in unemployment levels. As long as the Fed sticks to this recently outlined playbook, it seems apparent that at least the first half of the next decade will provide a poor environment for cash and a decline in purchasing power. This result would simply continue a consistent trend as 1-Month US Treasury Bills – a proxy for cash returns – have lost money to inflation every calendar year since 2009. 

Measurement: 30-Day T-Bills vs. Consumer Price Index

7) Social Security taxes are significantly expanded to include income above the current limits.

The most recent Social Security Trustees’ Report estimates that the Old-Age and Survivors Insurance and Disability Insurance trust fund reserves will be depleted in 2035 and that just three-quarters of the scheduled benefits will be available from Social Security tax income after such time. With the clock inching closer to this deadline and confidence in Social Security’s health waning, policymakers will have to address the impending shortfall over the next decade. Although there are several possible solutions that could be part of the fix including an increased retirement age or changes to the annual cost of living adjustments, the most politically feasible solutions based on public sentiment would be on the revenue side rather than any changes to the benefits equation. It seems likely based on this sentiment and political discourse that a broad expansion or outright elimination of the cap on Social Security earnings ($142,800 in 2021) is in store at some point over the next decade.

Measurement: Social Security wage base limit > $300,000 by the end of 2030       

8) The Backdoor Roth contribution loophole is closed

In February 2016, I outlined three financial planning strategies that were likely to end up on the chopping blocks over the coming years. One of those items – the “stretch IRA” – effectively died when the SECURE Act was passed in December 2019. Another item from that list that seems unlikely to survive for the next decade is the Backdoor Roth Contribution – an unintended loophole resulting from a 2010 tax law change that allows some high income earners to circumvent the income limits for making Roth IRA contributions. As long as it exists, the backdoor Roth contribution is worth exploiting but just don’t expect the opportunity to last forever. 

9) There will be at least three market corrections (decline of more than 10%) over the next decade

The S&P 500 Index has experienced 27 market corrections since World War II – an average of one every 2.8 years. Given rich market valuations which bake in lofty expectations and allow less margin for error, it is not going out on a limb to forecast that we confront at least three market reversals of more than 10% each over the next ten years. Predicting when such corrections occur, how deep they go, and how long they last is decidedly a fool’s errand.

10) The six largest stocks (Apple, Amazon, Facebook, Tesla, Google, and Microsoft) underperform an equal weighted S&P 500 Index

These six tech companies represent nearly 24% of the S&P 500 – more than the combined value of 371 other stocks within the S&P 500. Such massive concentration is historically unusual and while this alone doesn’t necessarily portend bad news to come for the companies, it reflects the stock market’s already lofty expectations for their forward-looking growth. Historically, the largest stocks underperform after they get large for the same reasons that growth stocks historically underperform value stocks – including the tendency of investors to extrapolate recent growth and overestimate the persistence of such growth. In addition to the challenge of extremely high expectations, several of these companies also face the threat of antitrust regulation over the decade to come.

Measurement: Equal-weighted basket of these 6 stocks vs. S&P 500 Equal Weighted Index

Barring any dramatic market swings in the final two weeks of 2020, we will experience the greatest calendar-year stock market recovery in history. On March 23, the S&P 500 was down 33.9% from where it started the year. As of December 14, the same index was up 13.5% in 2020 – representing a trough-to-peak gain of 64%. Chalk up another record for the year that is 2020.

There are plenty of lessons to be learned – or just to be reminded of – from this year. Among the valuable reminders is that doing nothing in the midst of sharp market losses (or gains) is negligent and irresponsible.

What’s that you say? You thought investment fiduciaries long preached a buy-and-hold approach that avoids market timing as the tried and true path to long-term financial success. Don’t such fiduciaries usually discourage market-timing? Did 2020 change that?

Nope. Still 100% advocates of a long-term, buy-and-hold approach. It is, however, requisite to understand that the long-term, buy-and-hold mantra is not a do-nothing strategy. It is a stay-the-course strategy. There’s a big difference between letting the wind take you wherever it will and readjusting the ship’s direction to maintain the targeted course. This is a fundamental but misunderstood concept of prudent buy-and-hold investing.

Consider that there are really three broad approaches to volatile markets:

1) Do nothing

2) Stay the course

3) Change the course

The change-the-course strategy is a market reaction strategy that historically has the worst results of the three. It is the equivalent of turning the ship around because of unexpectedly strong winds as if we did not anticipate that there would be difficult conditions along the way. Dignified investors who reduce risk in the midst of losses tend to label it as “going to cash until things settle down” or a more professional sounding theme like “market-based hedging”. Whatever it is called, 2020 produced another stain on the track record of the change-the-course strategy that sells stocks amidst market losses. And while 2020 was unique in a number of ways, it was not unique here. Four times during the past decade, the stock market suffered a drawdown of more than 15%. In all four of those instances, stocks quickly reversed and had fully recovered all losses within 138 trading days.

What about the do-nothing strategy? Consider the case of Rudolph in 2020. He started the year with 60% stocks (iShares All Country World Index ETF) and 40% bonds (Vanguard Total Bond Market) and did absolutely nothing – resulting in a 2020 gain of 10.8% (through December 14). Contrast this with Rudolph’s mentor, Vixen, who used rebalancing rules to apply a stay-the-course strategy to his investments. When the stock allocation departed the 60% target by more than 10% in either direction (54% / 66%), Vixen immediately rebalanced back to the 60% target. Employing this stay-the-course approach meant that he rebalanced investments on March 16 to buy stocks and on June 8 to pare back his stocks. Diligently setting the ship back to course during the choppy markets resulted in a return of 13.5%.

In sanguine times, there is little or no difference between staying-the-course and doing nothing. They are effectively one and the same. But when the stock market experiences a year’s worth of volatility in a few hours or posts several of the 20 most volatile days in stock market history as it did in March and April 2020, there is distinct opposition between staying the course and doing nothing.

Case in point: just 56 trading days into 2020 – and without any corrective rebalancing – Rudolph’s do-nothing portfolio that started as 60% stocks and 40% bonds became 50.6% stocks and 49.4% bonds. Whereas Rudolph started the year with 20% more in stocks than bonds, the two allocations were nearly equivalent by mid-March.

Lessons Learned from 2020

There are a lot of lessons to learn from 2020. But keeping to the topic of investing and market volatility, here are a handful of the fundamental takeaways:

1. Staying the course does not mean doing nothing. When a target investment allocation is established, it will immediately deviate from target as the market moves. It is practical to let the allocation drift from target within reason. Letting the allocation drift materially off course as occurred for nearly all investors in 2020 without any correction (rebalancing) defeats the purpose of even having a target in the first place. It is the functional equivalent of setting sail from New York to London but letting the wind redirect you to Senegal without correcting course.
2. 2020 provided a textbook case for the benefits of rebalancing. We covered a simple 60/40 example above but the results were similarly beneficial regardless of the targeted stock/bond allocation. The uniqueness of 2020 was that because of the dramatic intra-year volatility, the rebalancing benefits played out over a very short window of weeks rather than over years.
3. One of the primary reasons that disciplined rebalancing works is because it contra-trades relative to human emotions. Rebalancing inherently reduces risk when risk premiums are low (fear is low) and adds risk when risk premiums are high (fear is high). The profits from rebalancing come from the bulk of individual investors who do the opposite – trade based on emotions (buying when perceived risk is low, selling when perceived risk is high) rather than trading based on a discipline.
4. 2020 provided support of “tolerance band” rebalancing as optimal to calendar rebalancing. Tolerance band rebalancing is simply a disciplined approach like the one employed by Vixen where allocations are allowed to fluctuate within tolerance bands but when they “break the bands”, the allocations are rebalanced back to targets. Alternatively, calendar rebalancing tends to rebalance once a year on a preset schedule, regardless of intra-year volatility. In a year like 2020 where there is dramatic intra-year volatility, once-a-year calendar rebalancing often fails to extract the significant benefits of rebalancing. An investor who simply evaluates her portfolio every December would find roughly the same allocation in December 2019 as December 2020, losing out on the intra-year rebalancing premiums. While there are varying methods to apply Vixen’s tolerance band rebalancing approach, the evidence demonstrates that any reasonable form of his approach is optimal to calendar year rebalancing.
5. Annual rebalancing is practical but suboptimal. For individual investors who do not have time to regularly monitor their allocations, calendar rebalancing is a reasonable balance between optimization and practicality. For advisors who charge a fee to monitor and manage portfolios, there is really no excuse in the Internet age to maintain a legacy calendar rebalancing approach in light of all the benefits of tolerance band rebalancing and the pervasive technology to perform it.

Have questions, comments, or general thoughts on the concepts above? Please use the comments section below to share.