A Dismal Outlook

In GMOs most recent letter, Jeremy Grantham leads off the piece with, “At GMO these days we argue over three very different pathways to a similar dismal 20-year outlook for pension fund returns…A problem for investors following GMO’s writing is which of these three alternatives to choose”

With this in mind, let’s take a look at some of the potential paths a low return environment can take. Unfortunately, investors don’t get to choose what returns will be over the next twenty years or the path we’ll take to get there, but I thought this would be an interesting thought exercise nonetheless. I should also mention that when Grantham talks about the paths towards dismal returns, he’s talking about the fundamental drivers that lead us there, not price, but I’m the captain now.

Below is a chart showing three different ways stocks can achieve a 2% annualized return for the next 20 years. The red path shows a 36% drawdown over the next six years followed by a sustained recovery, the black path shows a 100% return over the next ten years followed by a -28% return over the next ten years, and the blue path shows a slow and grinding path without any noticeable breaks.

A 2% annualized return over twenty years would put pressure on investors regardless of the path it took to get there, but psychologically, the blue line might be the least desirable path. Imagine twenty years of slow and de minimis returns without much movement in either direction. Today it feels like investors have one foot out the door every time stocks come down a little as they attempt to front run the next big selloff. Another twenty years of this would be torture.

The black line is also hard to imagine and this would probably cause lasting psychological trauma. A 100% return over the next ten years would likely take valuations into Japan territory and the 30% bust to follow would give enough ammo to the “I told you so” crowd to forecast dire warnings for the rest of our lives.

If I had to choose one of these paths to follow, I’d go with the red. A -36% return over the next six years followed by a nice steady and lengthy recover would clean out some of the excess and remind investors that risk still exists.

Unfortunately we don’t get to choose what future returns will be or the path they’ll follow. What we can control is how we react and respond to brilliant investors with a not so rosy outlook.


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