Nearly all investors know that stocks are for the long term. Buy low-cost stock-owning mutual funds or a diversified bundle of individual shares and hold on to them until you retire (or later). History shows that you’ll get average annual returns of 10%. A dollar invested today turns into $8 in 20 years. What could be simpler?
But history, of course, tells us about the past. It may or may not tell us about the future. Lately, some smart economists and other financial experts are saying the future won’t be as fulfilling as the past.
Gross domestic product is the single best indicator of economic health. Since 1947, U.S. GDP, the sum of all goods and services produced, has risen at an average rate of 3.3%. But since 2001, the average rate has been just 1.9%. The last time GDP grew more than 3% was in 2005. We seem to be in the midst of a secular, or long-term, slowdown. GDP fell at an annualized rate of 0.7% in the first quarter of 2015, and Michael Feroli, J.P. Morgan’s chief U.S. economist, said recently that he “may have been too optimistic” in estimating annual U.S. growth at 1.75%.
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Sluggish recovery. A real danger sign is that we haven’t had a sharp rebound from the 2007–09 recession. Typically, the economy behaves like a rubber band: big drop, big snapback. But not this time. In the aftermath of the 10 downturns we’ve had since World War II, it took a little less than two years, on average, for employment to get back to its level at the start of the downturn. But following the most recent recession, it took 6½ years. (Even more ominous, the three slowest rebounds have occurred after the past three recessions.)
In August 2012, Northwestern University economist Robert Gordon published a paper with the provocative title, “Is U.S. Economic Growth Over?” He makes a convincing argument that it pretty much is. “There was virtually no growth before 1750,” he writes, and “the rapid progress made over the past 250 years could well turn out to be a unique episode in human history.”
The direct relationship between the economy and the stock market is complicated. In the short term, the link between GDP and share prices is nonexistent. But over the long term, it stands to reason that businesses won’t collect as much revenue and generate as much profit in a stagnant economy as they would in a robust one. I’d rather own stocks in an economy growing at 4% a year than in one growing at 1%. Who wouldn’t?
Then again, if you knew for sure that the U.S. economy was in a secular slowdown, should you change your investing strategy?
Before I answer that question, let’s go back to Gordon. He believes that the most recent industrial revolution—-which brought us personal computers, the Internet and mobile phones, among other technological breakthroughs—-has been a dud. It hasn’t done much to increase productivity—that is, generate greater output from the same input. And productivity growth, combined with population growth, is what creates GDP growth.
By contrast, the first two industrial revolutions had enormous impact on productivity. The first, from roughly 1750 to 1830, brought us steam-powered engines and railroads; the second, from 1890 to 1972, brought airplanes, air-conditioning and improvements in public health that increased life expectancy by more than 20 years. Gordon believes we have been living off the diminishing benefits of the second revolution (IR #2), while the third brought a short-lived productivity revival from 1996 to 2004, but not much more.
Gordon’s point is that “many of the original and spin-off inventions of IR #2 could happen only once—urbanization, transportation speed, the freedom of females from the drudgery of carrying tons of water per year, and the role of central heating and air-conditioning in achieving a year-round constant temperature.”
In other words, those gains are already built into the economy. We can’t get any more growth out of air-conditioning. Tyler Cowen, an economist at George Mason University, makes a similar argument, claiming that Americans have plucked all the low-hanging fruit. For example, we’ve already taken advantage of all the free and fertile land.
Stanley Druckenmiller, a billionaire former hedge fund manager, points to yet another drag on the economy: an aging population that will present a “massive, massive problem” for the U.S. over the next 15 years.
Sorry for all the pessimism, but the evidence is hard to deny. Now the big question: What does all this mean for investors? If economic growth slows by half—say, from 3% to 1.5% annually—then future stock returns will fall as well, from about 10% a year to maybe 7%, or even less. U.S. stocks have been booming lately, returning an annualized 22.4% from the start of the bull market on March 9, 2009, through June 5. That increase may be the result of the huge hit the market took during the financial crisis, or it may be because investors are anticipating a better economy than we are likely to get. Either way, the outlook is not good.
If you buy into the secular slowdown theory, consider shifting some of your stock investments from U.S. companies to areas where the low-hanging fruit is still blooming: developing markets such as India and China, which are still feeling the effects of IR #2. Check out iShares MSCI India (symbol INDA), an exchange-traded fund, or Matthews China (MCHFX), a mutual fund that’s a longtime favorite. Assuming you have a reasonably high tolerance for risk, put 20% of your stock portfolio in emerging markets.
As for U.S. stocks, I still believe that we have not absorbed all of the benefits of IR #3. The big things—food, shelter, education and transportation—haven’t changed much because of the computer revolution. They probably will at some point, but it is nearly impossible to pick winners and losers among individual companies. A better strategy is to pick diversified businesses that will benefit from innovation—for example, private-equity firms, which typically borrow money to buy companies, then revamp them and sell them, often for large profits. Consider Blackstone Group (BX, $42), Carlyle Group (CG, $29), Fortress Investment Group (FIG, $7) and KKR (KKR, $23).
With U.S. population growth expected to fall to just 0.5% annually by 2040, compared with nearly 1% today, and with more people shopping and working at home, I would stay away from real estate. What I would really like to buy are great logistics and transportation companies. As consumers rely more on Internet orders, the business of delivering the goods is enhanced. But beyond FedEx (FDX, $182), I have no brilliant selections.
Finally, some smart operators are putting their chips all over, not knowing which number will come up on the technological roulette wheel but ready to profit from whatever eventually hits. Among well-established firms, Amazon.com (AMZN, $427), General Electric (GE, $27), Google (GOOGL, $550) and Microsoft (MSFT, $46) are good examples.
In a low-growth, low-inflation environment, there’s nothing wrong with 7% annual returns from the stock market, if that’s the new normal. So also own index funds, such as Vanguard 500 Index (VFINX). That way, if I turn out to be wrong and growth picks up, you’ll still be a winner.
James K. Glassman, a visiting fellow at the American Enterprise Institute, is the author, most recently, of Safety Net: The Strategy of De-Risking Your Investments in a Time of Turbulence. He owns none of the stocks mentioned.