Are Stocks Facing a Lost Decade?

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This is Greg Bartlett for Barron's The Way Forward. Our topic today is the stock market and why it may be in for a lost decade. My guest is Rick Bookstaber, who has held Chief Risk Officer roles at Morgan Stanley, Salomon Brothers, Bridgewater Associates, and the University of California Regents. And he's also served in the US Treasury in the aftermath of the 2008 crisis. Rick is the author of The End of Theory "A Demon of Our Own Design," and has a PhD in economics from MIT, and he's the founder and head of risk at Fabric. Rick, welcome.

Thanks for having me on.

Thanks so much for joining us. So there is an awful lot to dig into, but before we even go there, I just wanted to bring to the listeners' attention an interview that you did with Barron's, which was the last I could find, in May of 2007 with my former colleague, John Kimmelman. And at the time, the stock market was near an all-time high. The Dow was around 13,400, thereabouts. And you warned about derivatives and how instead of them helping risk managers protect against losses, that you thought that they would in fact have the opposite effect. Less than 2 years later, stocks were cut in half. So you could take a victory lap on that one. That was definitely impressive. So before we talk about today and what you see for the next decade, first let's go back to 2007 when the market was at an all-time high in May 2007 before the crisis. What were you seeing that others weren't? I mean, directionally you're pointing to derivatives, but more to the point, you talked about the plumbing of the system and not just the surface-level fundamentals, but can you maybe expand on that or add to something I have not mentioned?

First of all, it's not so much seeing something that other people aren't seeing because there's nothing I could say where people say, oh my gosh, I didn't know that was there. It's really more either connecting the dots to how one issue could propagate out to affect another, or it's realizing that something creates a vulnerability where other people think, "Oh, big deal. That's not a problem." I mean, the poster child for that, you know, was in the mortgage area. And so the issue before 2008 was really, you could start with something very foundational or structural. We had financial instruments that were getting more and more complicated. People say, innovative, but that actually means opaque and complicated. We are finding leverage growing in all sorts of ways that weren't really apparent. So basically, people want to lever and they're finding ways to add leverage under the covers through clever instruments. And we had issues of lack of transparency in terms of hedge fund exposures, in terms of bank exposures because they held a lot off balance sheet, and in terms of the risk of bonds because of sort of bad behavior on the part of the rating agencies. So you could look all over and none of those things would be considered, gee, I didn't know about it. But when you add them all together, you get this cycle, which is a classic cycle, really, in crises, where there's an initial catalyst event that leads people to have to sell because they're leveraged. When they sell, they discover there isn't the liquidity that they need. So prices drop even more, and then they have to sell more after that. And the thing that really differentiated 2008 from other crises was the epicenter of it was in the banking system. And it affected short-term rates, which are kind of the lifeblood of the entire financial system. That's how people get funding. So it was a little bit like a stroke. You know, the blood flow was blocked to the brain, to the banking system, and through there to the broker-dealers. So that may be a little longer answer than you want, but that's kind of the essence of what was going on.

Let me first get a better grip on your assertion in terms of handicapping the likelihood that we may be in for a lost decade. I mean, do you think that's possible? Likely? I mean, can you first begin with that and then we can dig into your reasons for that?

I think it's substantial enough that you need to talk about it and you need to think through how you will act if things start to move in that direction. You know, is it a 5% or a 40%? You know, it's always difficult to try to pin a number on it, but it's something that you can't— it's something that you shouldn't ignore, you know, if you're really trying to think about risk in the markets.

What's the argument? What are your main points here?

The idea of lost decade is something that we all know about from Japan. They had actually more than one lost decade, where the lost decade was essentially the market goes nowhere. And so if you had money in the market, you look back 10 years later or whatever and say, gee, I thought I'd make some money here to help for my retirement. And I haven't. People don't really think about it that much for the US, but we've had post-World War II, or actually, including World War II, 3 cases of lost decades plus. One of them where I'm measuring it based on the S&P market appreciation. One of them was '37, 1937 to 1951. Another was 1968 to 1981. And the third was 2000 to 2014. Now, if you looked, say, at 2000 to 2014, you'd say, no, no, no, wait, the market was up, it went down, but then went back up again. Yeah, but then it went down again and up again. Same thing in the '70s. The market went down, up, down, up. But the point is, if you were sitting there in 1981, or if you're sitting in the market in 2014, you could look back and say, gee, the market's on an appreciation basis, the market's the same place it was 14 years ago. I've gone nowhere. And then finally, it goes up for good. So that's the notion of a lost decade. And it's more than a lost decade.

What would be driving this going forward? What's the argument?

So it's never one thing. It's hard to find any one thing that can cause trouble for the market for 10+ years. If you look historically at big events, say markets down 15%, 20% or more, In any one event, they tend to recover in anywhere between 1 and 3 years. Recessions take longer. Bubbles like a tech bubble burst, it takes shorter time. The reason you get this long-term flatness in the market is because one event follows another, and it could be just coincidentally, but a lot of times it's because the first crisis makes the market so vulnerable that the next event, when it occurs, kind of gets pushed over the edge and can cause trouble where it might not otherwise. So you have to sort of say, not what's the risk, what's the scenario right now? You have to say, what's the scenario right now? And what are the things that are sort of sitting out on the sidelines that then can come into play down the road. With the 1970s, it was inflation first, and then it was, you know, a series of issues with oil, for example.

You mentioned in the crisis that with the derivatives, it wasn't that you saw them and others didn't, it's that others underestimated their potential and actual impact. Is that similarly manifesting itself now where there are are things that everyone's looking at, but people are not giving sufficient attention to?

I think so. Part of it is everybody's somewhat myopic. You know, you look at the thing that's really an issue today. The big issue today obviously is recession or stagflation. And, you know, it is, it is a very big risk. But there are things that can come into play that maybe are slower moving, that can trigger a continual issue. One of them is climate. And again, everybody knows climate, right? Everybody knows it's going to be a problem. I mean, I guess there's some people who don't, but generally it's accepted now that that's the case. People make the mistake, I think, of thinking, okay, it's a 10, 20, 30-year issue because people project out what will the really dire issues issues tend to be 20, 30 years out or more. But there are two things. One is the way the markets work, as we know, is they don't react when the thing occurs. They react based on the expectation of it occurring. So if people suddenly wake up and say, oh my gosh, you know, as I project forward and see what might happen and discount that back to today, I've got some of my stocks are going to take a hit. And so they'll drop right now. So if we come to this aha moment and you get a lot of press, one thing after the other, climate is going to have a problem for the markets. But it's not just looking forward and discounting back. We've already seen over the summer issues that clearly have an economic and through that a financial impact. We've seen problems with hydroelectric power like in Finland. On the West Coast of the US because of drought. We've seen problems with nuclear power in France, not only because of drought, but because the rivers are getting too warm to accommodate the cooling. We've seen traffic on the Rhine reduced to where it's about a third of what it normally would be, which affects the supply chain. And then there's the whole issue that we're starting to see with what unfortunately would be called heat death. Which inhibits labor resources. So climate is one. Another one that's just coming into people's view is what might be called reduced globalization or deglobalization. Arana Fujuhar has a book that just came out called Homecoming. Yellen talked about friend-shoring in a speech about a month and a half ago in Korea. The point is there's going to be a shift a shift in the supply chain, moving more towards home and towards our allies. And that's going to create stresses to the market as well. In the long run, it may be beneficial, but short term, it can also cause problems in the geopolitical issues.

Not to mention inflation too. I mean, you're going to have a less efficient system.

Yeah, that's right. Yeah.

You've also spoken about the impact of long-term demographics.

Yeah. So if you want to go off So climate is longer term. Deglobalization and its effect will be longer term. That is, we'll see it moving forward like a slow motion, like a supertanker trying to turn. Demographics even goes out further, but it's undeniable. So it's kind of ironic that the things that are furthest out in some cases are the most clear in terms of occurring. Climate will take a long time. Demographics will take a long time. But we know today what the workforce, absent immigration, what the worst workforce will look like 20, 30 years from now. A place that's going to be really hurt by this is China. There's some estimates. Now we're going out a long ways, but there's some estimates that in 100 years, the population of China will be half of what it is right now. We don't have to go out like that. But even over the next 30 or 40 years or 20 years, there's going to be a substantial impact in terms of drop of labor. We already know it's an issue for Japan, also for Europe. So subject to what we can do technologically to buffer that, that's another effect where even before it occurs, if people suddenly have an aha moment there, it'll have an effect on the markets.

And to what extent do you think that automation might be able to fill the void?

Well, that's the real wildcard. And that goes in the other direction of some events that are long-term and you can sort of pin them down. You know, the key for technology is artificial intelligence. And it's really hard to know where that puts us. But that actually is another risk that I put out there as a long-term risk. But it's unclear, does it benefit or does it hurt? What does it do generally. But really, climate, demographics, AI, in my mind, are the long-term risks that matter if you're an advisor and you have clients whose timeframe is like 20, 30+ years.

Let me ask you, play a little bit of devil's advocate on this long-term forecast. Okay, so I'm going to use some historical numbers and I'm just curious for you to address that and, you know, make the argument as to why you think this will be different. So since 1950, And I'm using numbers, data from YCharts that Michael Batnick ran on his blog this month. It indicated that the S&P 500's fallen 25% 9 times since 1950 and that stocks were higher in every 3, 5, and 10-year period afterwards. And the average gains were like 36% 3 years out, 83 on 5, and 213 on 10. How do you reconcile what the historical data shows with this? And I recognize that declining rates were part of the backdrop for much of this, and going forward, we're likely not gonna have that same supportive rate environment, but can you just let me know, you know, what you think about that?

First of all, you have to, distinguish appreciation-based versus total return. So, you know, are you including dividends or not including dividends? Are you looking at just the value added through appreciation? Long term, well, I think a key issue is, and, you know, I think I'd have to see what he's looking at, but In terms of the S&P, the statements of the market being flat over the periods I'm looking at are kind of just sitting there. If you just go to Yahoo Finance or whatever. But I think his point, if I'm reading into it, is a good one, which is we have ups and downs. We have periods where the market drops 25%, 30%. I mean, really, in 2008, 50% plus. %. But a lot of times, if you're a very long-term oriented investor, it doesn't matter. In fact, one thing an advisor can do is try to put these sorts of events in perspective for their client. Because if you're a hedge fund or portfolio manager or whatever, you know, a drop of 30-40% is a big deal. Most of the time, though, those things recover, as I mentioned before, over 1 to 3 years. So if you're an individual with a long time frame, you can just sit back. You don't have to worry about it. And, you know, a good thing an advisor can do is prevent the need to sort of talk their client off the ledge by realizing that. So, and if you go long term, one thing that you can do again, just with Yahoo Finance, is take the S&P 500 from, say, 1935 on. I don't get the 2009 in there because that really was kind of a different world. But if you start in '35 or '40 and now put it in log terms, so now you're looking at returns. You'll see a line that's like straight. It looks almost like a straight line, a very constant type of 7 to 8% slope. So long-term, it's like the markets do really well. But if you put a magnifying glass on there, you'll see these periods where if that period happened at the wrong time for your client, it would be a big deal. If it happened at another time for your client, it wouldn't matter at all. And the times where it's possibly a big deal are these lost decade periods. And here's the reason that if, if basically the market goes nowhere for 12 to 15 years, it's not like, okay, I'm flat, I'm kind of the same place I was 15 years ago. Well, yeah, technically that's true. But the expectation you reasonably would have had is that the appreciation of the S&P would be like 7+%. So you're actually down over 50% from where you reasonably would have had an expectation to be. And that obviously can be a really big

deal. Yeah, and I would just interject to add that your average investor, the return that the average investor earns actually is far short of whatever the S&P 500 returns because they're often buying at higher points and selling. They like— yeah, so it's very— that further adds to the

difference. Well, not only that, they're not 100% in equities. Of course. But, you know, people use these actuarial rates. When I was at University of California, every pension has an actuarial rate, and they almost always are between the high 6% and the high 7%. And long-term, you know, all empirical analysis bears that out. There's one academic study that shows that's the case going all the way back to the

1800s. And you, with your company Fabric, you're working with advisors helping them to manage risk for clients. What are you hearing from advisors or what are clients looking for or what are some of the discussions that you're

having? What we try to do with clients is I call it risk-aware portfolio design. So it's kind of risk management moved one step closer to what advisors need. Portfolio design is either constructing a portfolio and constructing the target for client or rebalancing it based when it moves too far from the target or when a client has changed their goals and objectives, which happens all the time, obviously, through a person's life. And then trying to make sure that in terms of the key objectives the client has, they're not going to be kind of blown out of the water. So, like, a typical client is going to be interested in security. They don't want to kind of be out on the street. They want to be able to have enough money to maintain their lifestyle, or at least whatever lifestyle they imagine when they retire. And if they have the dry powder, they want to move towards aspirational goals. This is Ashvin Chhabra's structure, which I really like a lot. He has a book called The Aspirational Investor, where he does this. So what we do is try to take a portfolio. Here's the thing, you can't approach a client and just say, here's your portfolio, here's the return. If your client were a portfolio manager or a hedge fund, you could, that's what they care about. But for your client, it's Here's a portfolio. Here's your goals or objectives. Here's the risk of the portfolio. Here's the risk of your goals and objectives. How do those tie together? So it's like, you know, you have to clap with two hands. And then you have not only risk, but, you know, changes over time and what those objectives are. So risk management, it turns out, for an advisor and their client is a multidimensional, much more complex exercise than what's done for an institution. And unfortunately, almost all of the horsepower in risk management over the last 20 years have been focused on

institutions. And let me ask you, I mean, this year, as you well know, has been incredibly challenging. Stocks— S&P is down 25%, NASDAQ is down 33%, Dow is down 19%, and then the bond market's getting pummeled this year. And then with inflation, cash is getting hurt. Where do you see relative value today, given that it's a pretty challenging

landscape? Yeah, it's a very challenging landscape. People were sort of dumbfounded on what's happened to 60/40 portfolios because people forgot that bonds actually can drop. I mean, a 10-year bond can go down 10% and 20%. The only time a bond is really a safe investment is when it's matched to your liabilities when you're doing duration matching. So we've had a difficult year because it's sort of the perfect storm between bonds and stocks. Nobody should be surprised what's happened to technology in the NASDAQ because that was totally crazy. I think the first thing is that, as you just said, we're down 25%. Well, the worst we've ever seen is down a little over 50%. And, you know, as you pointed out, typical drops are 30%, 40%. So things are pretty bad, but, you know, you can sort of have a glass half full orientation, say, well, at least, you know, whatever pain I felt, you know, I have more to go, but it's not like it's going to go down another 40% from here unless we have something that's totally out of this world. But I don't think we're going to have anything close to 2008. So I think the first point is to realize we've already taken pain. And if you're not leveraged and if you have a long timeframe where you're not going to have to take money out of the market, either you don't do anything right now, you know, you don't sort of panic and start to sell, or if you do have dry powder, there is some point in here where there's an advantage to move back into the market. And it doesn't matter, you know, it's not an issue of bottom fishing. It's simply things are settled down. And so the longer you wait right now, the more opportunity you have. And this gets to sort of the other side of things, which I mentioned already, that if you have this sort of perspective, it's really helpful with a client. Because there's a lot of clients right now, I'm sure, especially if they were in the NASDAQ, or if they were in 60/40, who really are wondering, oh my gosh, what am I supposed to do now? If you show them this sort of return over time for the S&P, if you show them how these events typically resolve, and if you gird them for the potential of one event leading to the next so that you might have a period of 10+ years of things being flat, the odds are that for their goals and objectives, unless they're baby boomers where they really are on the cusp, they'll realize they can work through it and they don't have to take extraordinary

steps. Are they generally receptive and accepting of that message? I mean, given that it might not be the message they want to hear, even though it might be reality, or does it all

depend? I mean, do you— I don't talk to the clients. I talk to the advisors of the clients. Advisors like what we're doing a lot because it can take scenarios and take exposures and put them in context so that they can communicate well with their clients. And the other thing is that we use a factor-based approach. We have partnership with MSCI, which has a very strong factor model. And so one thing that's really attractive when you're dealing with a client and trying to go through these issues, whether it's here's what might happen to your portfolio if things go bad in the market, here's where you're sitting now and how we have to readjust given your new objectives, or given what's happened in the market, here's how you've strayed from the target and how we want to try to get back to it. You're better off doing that using factors than trying to deal with the assets themselves because you might have, you know, 500 assets and it's like, how do you get your arms around that? But in terms of the bare risk exposure, the bare factor exposures, usually there's like a handful, maybe 10 that really explain the risk. So it's easier and they're intuitive. There are things like what sector are you exposed to, what country, what style, value versus growth and so on, so that you can really have a conversation with the client to understand where they're sitting, what the implications of an adjustment might be, what type of shocks in the market are really going to hurt them and which aren't. So the key thing that we've really armed advisors with is an ability to do portfolio design, do rebalancing in a risk-aware way, be able to customize it for each individual client, which you have to do because each client Well, it's even more than just each client is unique. Each client is unique and differently unique at each point in time in their life cycle. But, you know, so you want to do that and you need to do it in a way that you can have a conversation, participate in a narrative with the client. So that's kind of where we're trying to go with it. Under the hood, there's a lot of horsepower. But the key point is putting it in a form that really is intuitive to use and

communicate. Okay. To the actionable idea, what do you think listeners could do that would be easy to implement that might pay dividends fairly

quickly? I think I've mentioned this point earlier, but when you're in this sort of an environment, which is— you might call it a crisis environment. It certainly is a very difficult environment. The key thing which an advisor can do and where the Fabric application can help is provide perspective to their client to realize what the events now actually mean in the context of their objectives. How is it affecting their security? What will be changing for their lifestyle? What does it mean about their prospects for getting their second home or whether they're aspirational goals. And absent the potential of one domino hitting the other, so you get a lost decade, what you will find is that if you take the 2 or 3-year period of these sort of bad events and put it in the context of the 15, 20, 30-year period that many people are looking at, you know, that your clients may be looking at, You can sit back. You know, you don't have to take action during this period. And that's a really valuable thing because not only does it save grief for both the client and the advisor, but you're stepping away from the noise in the market. You're separating the noise from the signal. You're separating what's material for the client versus what's sort of material for CNBC. And I think that's the actual item is being able to have that conversation with strong analysis behind it, to be able to look at what's going on right now that is material for the client versus what's happening right now that's noise. There's one time when I had food poisoning, the doctor said it's violent but benign. You know, it feels like you're going to die, but you're not going to die. And I think a lot of what we're seeing right now goes in for an individual, not for a bank, not for a hedge fund, not for portfolio manager, but for an individual. A lot of it is noise versus signal. It's violent but benign. And that's kind of an action item that I think, you know, an advisor can really take home for a

client. Yeah, so really giving that, defining that perspective and just kind of— Yeah, that sounds like excellent advice. And it was an absolute pleasure having you on. So thank you very much for

joining. Yeah, you're welcome. Thanks for having

me. Well, thank you again. My guest was Rick Bookstaber. For more advisor-specific podcasts, please check out barons.com/podcast. For The Way Forward, I'm Greg

Bartalus. This podcast was brought to you by Wells Fargo Advisors. Looking for a firm your clients can't outgrow? Wells Fargo Advisors offers financial advisors full balance sheet solutions with wealth planning, investment products, banking, and lending that meet the needs of affluent to ultra-high net worth clients. Build your practice your way and on your schedule with independent and employee model options designed to meet your needs today and tomorrow. Learn more at