Financial services firm Natixis surveyed individual investors this year about their expectations of the stock market going forward. If individual investors are right, the Dow Jones Industrial Average would reach about 170,000 in 10 years. Professional investors are not nearly as optimistic. His estimates put the Dow at around 75,000. Why the big difference and who is likely to be right?
Let’s take a look at the figures. Individual investors think the stock market will return around 14.5% in a year post inflation (with a slight inflation it is closer to 17%). Professional investors think it will be closer to 5.3% after inflation. The long-term return for stocks is around 7% after inflation. Thus, individual investors think that the next decade will be twice as good for stocks as compared to the average return over the past 100 years. Why the optimism? This is most likely related to his experiences over the past 10 years when the stock gave a return of around 15% post inflation.
If the stock market is doing so well, why don’t professional advisors think it will continue? This is possible because professional advisors are trained to look at the long-term history of stock returns, not just the past 10 years. The returns of the stock market have jumped wildly over different time frames of 10 years. Cherry picking in a decade can make you overly optimistic or overly pessimistic.
For example, for the 10-year period beginning in 2000, stock market returns were negative at about 1% per year. Because these numbers are mixed, it means that an investor will have lost about 9% of their money in 10 years. Thus, you don’t want to have a terrible decade ahead or a great decade ahead. The future usually has some sort of inversion, that is, bad decades are often followed by better decades, and better decades are often followed by worse decades.
On paper it sounds like professional investors should be right. They are using longer term trends and trying to adjust for short term volatility which can distort the estimation of longer term numbers. It seems like a rational approach, and one you would expect a professional to take.
But there are two big wild cards over which the pros have no control. The first is what is called “animal spirits”. This wild card refers to the fear and greed nature of human decision making that can drive prices above or below their fundamental values over a long period of time. In fact, the book “Animal Spirits” by George Akerloff and Yale professor Robert Jay Schiller (one of the leading authorities on stock market returns) analyzes the impact of animal spirits on markets. It is quite a powerful force and sometimes the most powerful force in the markets.
The second is the policy of the government. Government policy has a significant impact on animal spirits. This can serve to supercharge it or squash it like a bug. For example, if tomorrow the Fed raised interest rates to 5%, you could say goodbye to this bull market. The value of stocks, bonds and real estate will tank.
If professional investors are wrong about the next 10 years, it will most likely be due to their assessment of government policy on animal spirits. Professional investors on average believe the Fed and Congress will eventually take the punch bowl. Greed will then turn into fear and usher in an era of very low returns. This has been the pattern in the past, so it’s reasonable to assume that at some point, we’ll find policies that will crush animal spirits.
Personally, I’m not so sure about it. The stock and real estate markets are integral to the economy these days. They represent the two biggest sources of wealth for most Americans, especially baby boomers, who are turning 65 at a rate of about 10,000 per day, according to Pew Research. If the Fed and Congress break those valuations, they’ll wreck the retirement dreams and finances of most Americans.
Now, because government leaders (particularly at the Fed) believe that at some point their job is to stifle the party, I expect them to try to suppress animal spirits. But the implications could be dire because they have facilitated a steep rise in stock and real estate values. The imbalances are so widespread that trying to correct them can cause huge volatility in the financial markets. Fearing another “collapse”, they can ride to the rescue with another dose of accelerator for animal souls.
As an investor, you need to pay attention to the broader trend of how government policy can affect animal spirits. These days, being right can be the most important thing.
Charlie Farrell is a Partner, Managing Director at Beacon Point Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and are subject to revision due to changes in market or economic conditions and do not necessarily pass. All investments involve risk, including loss of principal. Consult your financial professional for guidance specific to your circumstances.