Imagine driving a car moving down the road at 20 miles an hour. You hold a rope out the window. At the other end of that rope is a skateboard. If the skateboard is behind the car, yanking the rope pulls the skateboard forward, so the skateboard might temporarily speed ahead until it gets way ahead of the car and the rope tightens again. At that point, yanking the rope will pull the skateboard back, so even while the car continues down the road at 20 miles an hour, the skateboard actually loses ground for a while. Over the long-term, the car and the skateboard move ahead at the same speed, but the speed of the skateboard over shorter horizons depends on its position relative to the underlying trend.

The same proposition applies to the trajectory of numerous economic and financial variables. We have to be attentive to at least two things: 1) the central tendency of growth in underlying fundamentals, and 2) our current position, relative to that central tendency. The difference between the two is what separates longer-term growth from cyclical fluctuations.

I’ve detailed this dynamic extensively in the financial markets. Given present valuation extremes, the skateboard is so far ahead of the car that we expect S&P 500 annual nominal total returns to average just 0.6% over the coming 12-year period, even if underlying economic growth accelerates to historically normal rates. Combine that with depressed interest rates, where poor 10-12 year total returns are baked-in-the-cake, and our estimate of the prospective total return on a conventional portfolio mix of 60% stocks, 30% bonds, and 10% T-bills has never been lower. The chart below presents our estimates for these returns, along with the subsequent total returns (red line) that investors actually realized over the following 12-year period.

Given that typical pension fund return assumptions are vastly above our current estimates, it follows that we expect a rather severe pension funding crisis in the coming years. If the resolution of the present valuation extremes is anything like what has followed other speculative peaks like 2000 and 2007, investors will likely face a substantially different (and better) menu of investment opportunities within a small number of years. Dry powder has considerable option value.

Moving beyond the financial markets, we turn to the prospects for growth in the U.S. economy itself. We’ll begin first with the 7-10 year horizon, and then focus our attention on cyclical risks.