The past four years have been quite good for index investors. During that span, the SPDR S&P 500 ETF (SPY) has returned 63% to shareholders. That works out to a compound annual growth rate (CAGR) of roughly 13%, which is 30% above its long-term historical average yearly return near 10%.

More impressive is that the index was able to deliver that level of short-term performance with a negative year thrown into the mix. In 2018, the SPY dropped 4.6%. Fortunately, it rallied strongly this year to more than offset that loss. That’s the good news.

The bad news is that much of that gain was enabled by artificial stimulants. Namely, a huge corporate tax cut, suppressed interest rates, and investor willingness to pay a higher multiple for earnings. Over the same span that the SPY jumped 63% in value, annual earnings per share (EPS) improved by only 50%

Even that comparison is a bit misleading. Companies have been repurchasing their own stock, which drives up EPS. A dollar of profit divided into fewer shares results in more earnings per share. Corporate profitability, regardless of share count, is up roughly 40% during that time.

That means the index has grown at a rate roughly 50% greater than corporate profits. Perhaps the stock market can continue to advance without a commensurate increase in profitability in 2020. However, I wouldn’t bet on it. Some reversion towards the mean strikes me as more likely given the litany of economic issues that financial markets must digest over the next few years.

Pay Attention to the Deficit

Perhaps no other headwind will exert a bigger long-term impact on the economy than the federal deficit.

In its latest projections (updated August 21, 2019) the Congressional Budget Office (CBO) estimates: “Over the coming decades, deficits (after adjustments to exclude the effects of shifts in the timing of certain payments) fluctuate 4.4 percent and 4.8 percent of gross domestic product (GDP), well above the average over the past 50 years.”

From 1969 to 2018, the average annual deficit to GDP was -2.9%. From 2020 to 2029, the CBO is projecting that figure will widen to -4.7%. The CBO observes: “As a result of those deficits, federal debt held by the public is projected to grow steadily, from 79 percent of GDP in 2019 to 95 percent in 2029—its highest level since just after World War II.”

At the same time, economic growth as measured by GDP is projected to grow by an annual rate of 1.8% over the next decade. That’s a 20% decrease from the current growth rate of 2.3%. It’s not that the CBO expects American workers to become less productive, but that “the labor force is expected to grow more slowly than in the past.”

If the CBO is correct in its expectations for the next decade, it will be difficult for the overall stock market to continue growing at its recent pace. To be clear, that does not mean that it will decline in value. However, it does mean that passive investment strategies will most likely generate considerably lower returns over the next 10 years than they have over the past decade.

Time to Get Active

For that reason, next year could prove to be an inflection point for index investing. Active investment strategies, including individual stock selection versus indexing, should enjoy a resurgence in popularity.

A popular fallacy is that index investing will inevitably outperform active investment strategies over the long haul. True, index investing has performed extremely well over the past decade. However, bear in mind that timeframe commenced immediately after the last stock market crash.

Since then, the global economy has been driven primarily by central bank intervention, both here and abroad. Interest rates can’t go much lower. And if a Democrat wins next year’s presidential election, you can bet that some sort of tax increase will be coming in 2021.

That means the same forces that generated superior returns for passive investment strategies may soon start working in reverse. When that happens, active investment strategies will have an edge. While the overall stock market may have trouble making much headway, there will still be ways to achieve double-digit gains.

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