Trading Desk: What’s “Realistic” In Terms Of Risk And Returns?

After years of swinging wildly from euphoria to despair, a lot of investors could benefit from a refresher course in what kind of return profile is actually healthy and deserved . . . and when to feel either nervous or frustrated.

Let’s face it, the market hasn’t been “normal” for a long time now. With a crash at the end of 2018, a giddy pre-election rebound in 2019, the COVID rollercoaster of 2020, zero-rate madness in 2021 and then last year’s Fed meltdown, plenty of people working on Wall Street have never experienced anything but sudden and arbitrary extremes.

The volatility index or VIX hasn’t dropped below its long-term average in nearly three years. “Normal” levels here historically come in between 10 and 15. Anything lower is ominously quiet. Anything higher is a wild ride.

And the ride got wild when COVID started spreading around the world. That was back in 2020. We’re in 2023 now and the “calmest” days have barely gotten the VIX down to 15.

The wild days, on the other hand, have easily matched the 2008 crash and its aftershocks. Back then, traders had to live with an elevated VIX from 2007, when the wheels started coming off the housing markets and Bear Stearns, for about four full years before even getting their first hint of relief.

Put that into perspective and IF the impacts of the pandemic and the Fed’s gyrations are as severe as the 2008 crash, we could be riding this rollercoaster for another year or so. On the other hand, volatility means extreme upside as well as terrifying dips.

We’ve already seen that stocks can soar beyond credibility when the VIX is elevated. It happened in late 2020 and through 2021, just like it did in 2009 through 2011. The danger here is that after a period of tension and collapse, the rebound can feel unreal.

People who’ve suffered through a bubble boom and bust simply have a hard time trusting their “luck” when the market gets back on track. Every hint of upside feels exaggerated, artificial, unearned . . . unreal, a mirage. And anything gained from a mirage can just as easily be taken away again.

I think a lot of this pessimism is driving the market right now. Stocks that survived the last brief rate tightening cycle are bigger and stronger than ever, but they’re having a hard time staying above pre-COVID levels.

It’s not the fundamentals. It’s not rates. It’s Wall Street’s lack of context.

Here are the long-term averages. They’re what’s “normal.” Anything less than this is a bad year. Anything better is an exceptionally good year . . . and cautious investors might think about locking in their good fortune while they can.

U.S. stocks generally climb at a real rate of 6.38% a year. The “real” rate means it’s after inflation, so on average you can historically add another 2-3 points back. Add another 3 points for dividends and you’re looking at a nominal 11% gain in a typical year.

That doesn’t mean that high inflation means inflated appreciation. Inflationary years tend to depress returns . . . which is exactly what we’ve seen lately. The sweet spot in the cycle is when inflation is low or even dormant.

Remember, the long-term average on inflation is still around 3% and it practically can’t go below zero for any length of time. The math here means that for every zero, there’s got to be a 6% . . . and occasional bursts above that level have always been balanced by longer periods closer to zero.

Adjusting for inflation and reinvesting dividends, the S&P 500 has doubled roughly every 8 years. That’s normal. Anything faster will need to be balanced by something slower . . . or even a significant step back.

People were right to think the market was overheating back in 2021. But that’s the risk we take when we invest in stocks in the first place.

Stocks historically pay about 8% a year more than bonds. That’s the “risk premium” we get for enduring the rollercoaster and uncertain outcomes in the first place.

If that’s not good enough for you, you need to go far beyond the S&P 500 and accept a lot more volatility along the way. We do pretty well by picking the best stocks, but it’s still a wild ride.

Right now Treasury yields are around 5%. That’s telling us that the right stock portfolio should ultimately climb 13% in nominal terms . . . if inflation doesn’t get in the way.

These are historical numbers that go back over a century, across plagues, wars, turmoil and depressions. This is what “normal” looks like. Don’t settle for less. And don’t get nervous if the market gives you what generations of investors demanded and deserved.