Lost Decade

How to Benefit from AI (Artificial Intelligence) Without a Lost Decade

by

Quiz!

Which of these investments can do well thanks to the AI revolution? (There may be multiple answers.)

  1. An Asian renewable energy company generating very cheap electricity.
  2. A company whose stock went up 1,000% in recent years.
  3. A trucking company using AI to improve many aspects of its operation.

How to Benefit from AI (Artificial Intelligence) Without a Lost Decade

AI is having a big impact, with an expectation for a transformation that would improve lives all around the world. The promise of AI led to outsized gains for technology companies. The excitement pushed prices higher much faster than actual earnings and book values (intrinsic values) of some of these companies. The effect surpassed the dot-com boom, with S&P 500 Price/Book (P/B) even higher than the peak of 2000, and is now the biggest seen since 1929, the onset of the Great Depression.

This creates a dilemma: Do you buy companies that are involved in a worldwide transformation, hoping to benefit from earning growth, or do you avoid them given that the price growth surpassed the actual earnings many times over? The most recent case when prices (relative to book values, or P/B) reached close to the extreme of today, was during a lost decade – a 10-year decline of 30% for the S&P 500, and a 14-year decline-to-recovery for the Nasdaq. The Nasdaq lost 78% over a grueling 2.5 years. This was the result of very successful companies continuing to be successful while adjusting prices to be more in line with reality.

While different bubbles pop at different levels, the current bubble has a solution that avoids the big risk while still aiming high. The reason it is possible is that there are plenty of stocks and entire stock markets (countries) that are not priced high. One solution is to invest in deep-value (much lower than typical P/B) companies around the world, emphasizing non-US stocks (international and emerging markets), and diversifying across sectors. The benefits:

  1. Efficiency broadly:  AI makes companies across all sectors and economies more efficient, increasing their values.  The benefit depends on the speed of adoption, and the ability to adopt.  With company and sector diversification, you can enjoy an overall benefit, without the risk of a company- or sector-specific bet.
  1. Spread:  As happens typically in tech cycles, the world will transition from a few early AI developers, to competition (e.g. DeepSeek).  This punishes companies with valuations that reflect expectation for eternal dominance, and rewards new entrants that start with low P/B.

Quiz Answer:

Which of these investments can do well thanks to the AI revolution? (There may be multiple answers.)

  1. An Asian renewable energy company generating very cheap electricity. [Correct Answer]
  2. A company whose stock went up 1,000% in recent years.
  3. A trucking company using AI to improve many aspects of its operation. [Correct Answer]

Explanations:

  1. AI consumes substantial energy. A company with competitive pricing along with the appeal of renewable energy can enjoy growing market share in a market with growing overall demand.
  2. Just because a company’s stock surged, we can’t know what its future will be. It could still be underpriced, or it could have become overpriced through people chasing past gains without studying the merits of the investment, including the company’s earnings and book value relative to its current price.
  3. Many companies may benefit from AI in multiple ways. Those who implement it smartly can get a big benefit, regardless of their sector, including trucking companies.
Disclosures Including Backtested Performance Data

The Anatomy of a Lost Decade

by

Quiz!

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings.
  4. Extreme economic distress.
  5. Euphoria.

The Anatomy of a Lost Decade

In the 2000’s, the S&P 500 experienced a 10-year decline, on a total return basis (including dividends), and much worse after counting the negative effect of inflation. This was not the first time – the decade ending in 1974 had +1.2% return per year, while inflation averaged 5.2% per year. This article describes what may lead to such long declines, and how they look.

What led to lost decades? A diversified portfolio of companies that produces products and services for entire countries is not likely to shrink its production for 10 years. What led to the 2 recent lost decades was high valuations (high price relative to the earnings of the companies or book values) of the companies. During the decade, the valuations declined by more than 50%, to correct (and typically overcorrect) the unusual pricing.

How did they look? The two most recent lost decades involved a series of gain periods followed by big declines, erasing substantial gains.

Can you avoid lost decades? There is no way to perfectly time the market, since turning points vary between cycles, with highs sometimes (but not always) leading to higher levels. There are various approaches with varying levels of success, involving getting out of diversified investments that did far above average for 10 years, or selling when valuations reach extremes. The easiest one is to diversify and include investments with lower average growth. While it involves a sacrifice to the returns, it gets around so many strategies that fail.

Why most people fail at timing? Once you find a strategy that stood the test of time, and has sound logic to it, you still have a major obstacle to overcome. Selling high and buying low involves going against the grain. It involves selling the most loved investment of the time, that people believe will just keep going up, and buying battered investments that underperformed for many years.

Can you avoid lost decades? While it is very difficult to time the market, or at least soften the blow of tough stretches, there are several principles that can improve your odds:

  1. When you hear gloomy news, along with scary predictions, and the investments are very low (low valuations / low 10 year returns), get excited about the investment.
  2. When you see euphoria all around you, with the most positive news, and the investments are sky high (high valuations / high 10 year returns), have the ability pull the trigger and sell and switch to an investment that most people hate.
  3. Whatever strategy you choose, make sure that it passed 2 tests: the test of time & the test of logic. While these are not enough, I would not move forward without these in place.
  4. Don’t expect to successfully time within one day, week, month or even year. Short-term timing strategies are far more difficult than long-term ones.
  5. Have a very robust risk plan, accounting for cases much worse than experienced in the past, allowing you to stick with the plan in some of the toughest times.

Quiz Answer:

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings. [Correct Answer]
  4. Extreme economic distress.
  5. Euphoria. [Correct Answer]

Explanations:

  1. Wars end up leading to increased economic activity. Declines tend to be far shorter than a decade.
  2. Pandemics tended to create short-term shocks, not very long lasting.
  3. High valuations typically get corrected. When valuations reach extremes, such as x2 the typical or more, it takes a prolonged period of poor performance to correct those.
  4. Extreme economic distress can lead to declines, but without high valuations, they tend to get resolved in far less than 10 years.
  5. Euphoria tends to lead to very high valuations – see #3 above.
Disclosures Including Backtested Performance Data