One thing all investors agree on is the future will not be like the past.

A recent paper, How the Wealth Was Won: Factor Shares as Market Fundamentals, explains why that’s a problem for long-term investors.

Data shows the past 30 years were unusually good for investors. Specific factors that made those years so good are impossible to repeat in the future.

For investors, that means what worked in the past won’t work in the future. Buy-and-hold investors face the greatest challenge.

They enjoyed a unique time in history. Now they need to adapt. And active strategies present the best opportunities.

Why Did Stocks Go up so Much Since 1989?

How the Wealth Was Won is a National Bureau of Economic Research (NBER) paper.

NBER is the most respected group of economists in the country, if not the world. The authors’ goal is to explain the stock market.

They deconstructed stock market gains over the past 60 years. Their search explained why stocks went up so much since 1989. And the answer explains why that can’t happen in the next 30 years.

Many economists believe economic growth is responsible for stock market returns. Some studies show a strong connection between economic growth and long-term stock market returns.

In general, those are older studies. That connection broke down in the last 30 years.

How the Wealth Was Won shows why that connection broke down.

The table below shows stock market average annual returns matched economic growth from 1959 to 1988. Since 1989, returns more than tripled economic growth.

Average Annual Return 1959-2017

It’s impossible to overstate how important this data is.

For more than three decades, investors ignored the economy. They pushed stock prices up even as the economy slowed.

Now, the question is whether returns can continue to outpace economic growth. How the Wealth Was Won answered this question.

Explaining Where Returns Came From

Gross domestic product (GDP) growth has been in a downtrend over the last 60 years.

It’s expected to remain low for some time. Economists expect long-term growth to average 2% to 3% a year.

That means investors can’t count on economic growth. Fortunately, the authors of How the Wealth Was Won identified three other factors that contributed to growth in the past 30 years.

One factor was interest rates. As interest rates fall, stocks become more attractive to investors.

That’s simply because investors favor investments with the best returns. When interest rates are low, many investors choose stocks for greater growth potential.

Falling rates were an important factor over the last 30 years. Lower interest rates accounted for about one-ninth of the performance of the stock market.

Looking ahead, investors can’t count on that factor to help. Interest rates are at 320-year lows.

Bank of England Policy Rates 1800-2019

(Source: Financial Times)

Based on history, it’s reasonable to say rates can only move higher in the next 30 years. That creates a drag on stock market performance.

So far, we started with 3% economic growth and need to subtract from that for interest rates.

The Risk Premium

Another factor that contributed to stock market returns since 1989 was a change in the risk premium.

This is a little technical, but the risk premium is the amount investors demand for holding assets that can lose money.

One way to calculate the risk premium is to subtract the yield on risk-free 10-year Treasurys from the expected stock market return.

Risk premiums change over time. They rise in bear markets and fall when prices rally.

Now, the risk premium is about 4.3%, according to one model. In 2008, before the bear market, the premium fell to 3.9%. After the bear market, it rose as high as 4.8%.

Changes in the premium affect returns. When premiums fall, stocks are worth more because investors are willing to pay more for $1 of earnings.

From 1989 to 2017, the premium declined from 5.2% to 4.8%. That accounted for about 11% of the stock market’s returns over that time.

History says that from 4.3%, where we are now, there is little room for a significant decline in the risk premium.

This factor combines with slow economic growth and a potential increase in interest rates to point to low returns in the future.

To escape that fate, investors need to depend on the primary factor that drove stock returns from 1989.

The paper found that 54% of the stock market’s gains came from what the authors called a “reallocation of rents to shareholders.”

In simpler terms, the market went up so much because companies made more money, and they used more of that income to benefit shareholders than they did in the past.

OK, that still obscures the point. In the simplest terms, the market went up so much because income inequality increased.

It’s Not About Politics

Income inequality is a rallying cry for some activists. Others counter that inequality isn’t a problem.

I’m not picking a side or making a political point. I’m just sharing some fascinating research. The data carries an important message about the future.

To start with, we know companies in the S&P 500 Index reported record-high profit margins in the past few years.

Profit margins are the amount of profits per dollar of sales. Higher margins mean companies lowered their costs.

Labor is a cost to business. The next chart shows the share of sales going to labor. The decline since 2000 is unprecedented.

Business Sector Labor Share 1950-2019

(Source: Federal Reserve)

Labor costs probably bottomed.

If labor costs rise, companies will make less money. If they make less money, they reduce shareholder returns. That seems inevitable.

The Key to the Future

Summing up, market returns will be based on slow economic growth, and weighed down by all the factors that boosted returns in the past three decades.

The future looks bleak for buy-and-hold investors.

But I want to end with some good news.

The dreary future doesn’t matter. Actively managed short-term strategies can deliver the kind of returns investors need.

That’s important to remember. Markets are changing.

Investors need to lower expectations. And short-term strategies are the key to the future.

I have more details on this research in the video below:

The video also includes my weekly market outlook, which is the cornerstone of my short-term strategies.


Michael Carr, CMT, CFTe

Editor, Peak Velocity Trader