"What will the next 5 years hold?"

July 8, 2020 by Matt McCracken

Many years ago, I had a meeting with a rep from Altegris Investments.  (Altegris Investments is one of the foremost authorities on Managed Futures strategies and other kinds of alternative investments.)  In the meeting, he proposed a thought provoking sequence of questions and I thought I’d share them with you.

Initially, he asked, “What will the next five years hold?” 

My response with a shrug, “I have no idea, I don’t think many do.”

And he continued, “Will the next five years be like the last five years?”

And I responded, “Absolutely not.”

And then he suggested, “Well, then should be invest for the next five years like we have for the last five years?”

Nothing is definite except taxes, death and change.  We know the future will look different from the past, no doubt about it.  So is now the time to start reconsidering how we are allocating our capital?

Interest rates are at generational lows darn near zero.  Can they go much lower?  Can they go negative?  If they remain where they are, can equities return the same over the next five years?

Equity valuations are sky high as well.  Optimism regarding risk is at all-time highs when considering credit spreads and other measures of risk.  Historically speaking, high valuations lead to lower returns.  John Hussman, Ph. D., a vigilant student of stock market history, says the following in his most recent update titled "Iceberg at the Starboard Bow":

Market history, including the series of bubbles and crashes over the past 15 years, does not teach that valuation is irrelevant, but instead that a key distinction affects whether stability or instability is likely to prevail. When rich valuations are coupled with tame credit spreads and uniform strength across a broad range of market internals and security types, one can infer that investors remain tolerant toward risk. In that environment, risk premiums may be low, but there’s no particular pressure for them to normalize, even if the speculation is driven by mindless yield-seeking. Trend uniformity and well-behaved credit spreads are an indication of risk tolerance, which allows overvalued markets to remain overvalued without immediate consequence. In stark contrast, increasing dispersion across securities and sectors, deteriorating market internals, and widening credit spreads are all subtle but observable indications of growing risk aversion – icebergs that can easily rupture the Titanic of severe overvaluation. Monetary easing then no longer supports risky assets, because risk-free liquidity is no longer seen as an inferior asset. This risk-aversion creates upward pressure on low risk premiums, which normalize not smoothly but in spikes, resulting in air-pockets, free-falls and crashes.

Is it time to start reallocating capital to strategies that will outperform in a stock bear market?  What if both bonds and stocks decline in lock-step assuming due to a rising rate enviroment?  I can’t say if these events will take hold.  I cannot say what the next 5 years hold.  I can say that moving out of equities and bonds at this stage would definitely be “selling high”.  And I know there are a host of securities suffering from being "out of favor" with Wall Street that would be buying low.  Buy low, sell high...Seems like I have heard that before.