A Critical Long-term Framework for a Rigged Market

The old mantra your financial advisor tells you “Buy stocks! They will always compound at 10% every year!” is far from the truth.

Well, the idea that US stock market reliably compound at 10% every year is only right over extremely long timeframes (80+ years).

Let me show you some shocking facts that your FA will never share with you. Here is the chart of S&P 500 historical 20Y CAGR from 1947 to 2022:

There are 4 important takeaways from this chart:

#1. Yes, the long run average of S&P 500 return from 1947 to 2022 is 10.1% (nominal return). But in practice, even 20Y CAGRs are rarely close to that results.

For example — 18% CAGR in 1999 vs 3% CAGR in 2019! Ouch!!!

#2. The long run S&P 500 returns follow an exact 40-Year massive cycle with TWO phases (as shown in the Chart 2) :

• Accelerating Return Phase (Green) - 20Y CAGR keeps going up

• Decelerating Return Phase (Red) - 20Y CAGR keeps going down

Each phase lasts about 20 years (more on this later).

#3. Although there has never be a negative CAGR if your holding period is 20 years (yup, “stock market is rigged to go up!”), which part of the “cycle” you are at when you get in & out can make a massive difference on your over return.

Simply put — the longer you hold stocks does NOT guarantee a higher return. Which year you get in and which year you get out absolutely matters!

For example, let’s map out the one standard deviation band (13.9% to 6.3%) around the historical mean value (10.1%) as shown in Chart 3:

If I am in the green zone (above one standard deviation higher) but you fall into the red zone (below one standard deviation lower), then in real dollar terms, I could double my money 2-3 times faster than you!

#4. If we study the exact causes for each cycle peaks and throughs (as shown in Chart 4):

What we see at play in the chart 4, is the waxing and waning of two key equity valuation drivers:

• Cost of Capital (risk-free rate + equity risk premium)

• Return on Capital (sustainable competitive advantage, aka moat + high growth)

In the simplest terms:

The first peak (17.3% CAGR, from 1949 to 1963), came from US companies earning consistently high Return on Capital into the long post-war recovery.

US demographic and economic advantages gave them ample room to reinvest capital at much higher returns.

The second peak (17.9% CAGR, from 1984 to 1999), was driven by low Cost of Capital.

10Y yields fell from 16% to 4% over that period, dramatically reducing borrowing costs and lifting equity prices.

Ok, but how do all these matter today? Which part of the mega cycle are we at right now?

In my opinion, the charts I show you guys above could be one of the best frameworks to navigate where the US stock market returns will be over the next 20 years.

Let me explain:

The driver of the next 20 years will NOT be about declining Cost of Capital (yikes, no more “cheap money“).

10Y only yields 3-4% these days, this part of the equation ceases to be helpful in those analysts’ crazy DCF models.

Long run US stock returns (over the next 20 years, from 2021 to 2040) will be driven by corporate Return on Capital, and the ability to grow that capital more productively.

If companies can do that better than the past 2 decades, then the nominal and real return will certainly be much higher than 10.1%.

Therefore, this framework leads to 3 important conclusions:

#1. Growth stocks are a much better place to be than Value stocks over the next 20 years.

Companies that can both achieve high Return on Capital, and deploy incremental capital productively, will be the “Alpha”.

#2. We are most likely at the beginning of the next “Accelerating Return Phase“, and Tech stocks will be the major leaders.

The reason is pretty simple — there are just no other sectors can generate similar Return on Capital and leverage global growth opportunities.

My base case is that large cap tach stocks will be 40-50% of the entire S&P 500 index in 10-20 years time.

#3. S&P 500 needs fresh tech companies (the new “FAANG“) to take the lead for the next run.

The development of Artificial Intelligence will potentially be the single most important tailwind (unlock productivity, increase corporate Return on Capital) for the next bull run, and AI companies will play a significant role to lead.

I will save this point for another separate newsletter with much more in-depth deep dive.

That’s it for today.

See you next week!

Vic

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