It’s been a long
A long time comin’, but I know
A change gon’ come
Oh yes, it will —A change is gonna come, by Sam Cooke

Nicknamed “The Great One,” Wayne Gretzky has been called the best hockey player ever. Despite Gretzky’s unimpressive size and strength, his intelligence, stamina and reading of the game were unrivalled. Gretzky himself credited much of his success to advice he received from his father as a young boy, which was to “skate where the puck’s going, not where it’s been.”

As is the case with The Great One, superior investment results stem in large part from anticipating future developments rather than simply positioning portfolios based on the past or current environment.

The most powerful force in markets

Reversion to the mean is perhaps the most powerful force in markets: Periods of higher-than-normal returns have been followed by periods of subpar returns, and vice versa. The postwar expansion and steady market gains of the late 1940s and 1950s were followed by stagflation and choppy, flat returns in the 1960s and 1970s. In similar fashion, the great bull run of the 1980s and 1990s ushered in the lost decade of the 2000s, when stocks delivered negative to flat returns.

For as long as modern markets have existed, people have overreacted, both in good times and bad.

Following several years of strong economic and earnings growth, investors have repeatedly become overconfident that the proverbial party will continue indefinitely, causing stock prices to rise at a faster pace than earnings and multiples to reach unsustainable levels.

At the other end of the spectrum, during periods of recession when earnings either decelerate or contract, widespread despondency morphs into predictions of eternal darkness with no possibility of improvement, resulting in lower than reasonable earnings expectations, multiple contraction and fire sale asset prices.

The longer and stronger the expansion, the more irrationally exuberant people become, and the longer and darker the recession, the more illogically pessimism gets entrenched. Ironically, the most optimistic extrapolations reach a crescendo when they are least likely to be realized and the most pessimistic ones become most widespread when they should be least so. The exact anatomy and causes of different booms and busts change from cycle to cycle but the overall picture has remained tragically consistent. Plus ça change, plus c’est la même chose.

Markets have not been normal

Investors today have grown accustomed to well-above-average returns. However, the past 10 years have been highly anomalous from a historical standpoint.

Notwithstanding the daunting historical pattern of mean reversion, the post global financial crisis environment has been highly supportive of equities. Increased globalization, moderate inflation and low interest rates supported strong earnings growth and expanding valuation multiples, which in turn spurred above-average returns.

In contrast, today’s landscape is marred by trade frictions, stubborn inflation, ballooning sovereign debt levels and rising interest rates. Importantly, these structural headwinds for earnings growth stand in sharp contrast to today’s elevated valuations, with U.S., Canadian and European indexes all standing in the top fifth of their historical valuation ranges.

Given the historically inverse relationship between starting valuations and forward, ten-year returns, I am confident that average returns over the next ten years will likely be lower than long term averages, and perhaps meaningfully so. History seems primed to repeat itself, if not rhyme.

Without exception, BlackRock Inc., JPMorgan Chase & Co. , Morningstar Inc., Research Affiliates LLC, Charles Schwab Corp. and The Vanguard Group Inc. all expect equity returns in all regions over the next 10 years to be meaningfully below their long-run average rates of return. On average, they expect U.S. stocks to produce annual returns of 5.1 per cent, as compared with their long-term average of 10.2 per cent. The corresponding estimate for non-U.S. developed equities is 7.3 per cent versus their long-term average of 8.5 per cent.

What really drives the bus

A portfolio’s factor exposures refer to its relative weighting towards stocks with certain characteristics, such as low volatility (overweight lower versus higher volatility companies), dividend yield (overweight dividend payers versus non-dividend-payers), value (overweight value versus growth shares), and size (overweight small versus large-cap companies). Importantly, several studies have shown that between 55 per cent and 80 per cent of a manager’s outperformance or underperformance can be attributed to their factor exposures, while only the remaining 20 per cent to 45 per cent is typically attributable to the company-specific traits.

Portfolios that are overweight lower volatility and/or dividend-paying stocks have historically tended to underperform when benchmark indexes have delivered above-average returns. However, when index returns have been anywhere from below-average to negative, these attributes have tended to add significant value. Specifically, during the bottom third of past ten-year rolling return periods from 1926 to 2024, such portfolios have on average outperformed by an annualized rate of 4.9 per cent (61.3 per cent over 10 years).

The key to capital growth in a lower return world

Index portfolios have delivered well-above-average returns over the past 10 years. Against this backdrop, the additional return from non-index portfolios has often been of little, if any, benefit, even for the best managers. In contrast, index returns over the next decade are likely to prove underwhelmingly below average, regardless of country or region.

Lower returns aren’t the end of the world, nor are they reason to stuff your money under a mattress. However, they do necessitate rethinking your approach. Like The Great One, investors should go where the proverbial puck is going.

  • How an either-or passive versus active stock market investing strategy can impair your portfolio
  • Investors wondering when the stock market party will end are caught between FOMO and fear

At Outcome, we are preparing for an era of below-average returns with an algorithmic approach to investing in dividend-paying, low volatility stocks, both in Canada and internationally, primed to outperform when most needed.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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