Most of the last 40 years in the US have seen both low inflation and steady economic growth, a combination that is historically very good for large cap public equities.
However, the US is probably entering a period of “stagflation” now with high inflation plus labor force participation falling to 40-year lows, which means investors have to rethink their strategy.
This risk to future public equity returns is exacerbated by high valuations (in the 95th percentile of all recorded history) plus the prospect of slowing corporate profit growth.
New data over the past several years shows that the correlation between realized investment returns from venture and US large-cap public equity returns is close to zero.
Investors should look to alpha-producing venture capital to diversify risk across future market cycles.
Between 1982 and 2020, the US experienced a rare combination of steady economic growth and price stability. Over this period, real GDP has seen annualized of about 2.7% (with per capita growth ticking along at 1.7%) and the consumer inflation rate has averaged about 2%. This combination of low inflation, low and falling interest rates, and steady GDP growth (along with corporate profits growing even faster than GDP) was a very favorable one for large cap public equities.
Yet the last few months of economic data shows that we are about to enter a new macroeconomic period, one characterized by rising consumer price inflation and slower economic growth. Over the past three months, consumer inflation has ticked up to nearly 7% (a 39-year high) just as civilian labor force participation has hit a 40-year low, and the US economy is about 4 million jobs lower than its pre-pandemic peak.
See Figures 1 and 2 below.
It would be hard to find a professional American money manager who has any real experience investing in those kind of conditions – or really in any kind of conditions where US public indexes weren’t going up.
Yet the period from 1982- 2020 represents something of an outlier in US history.
There have been at least a dozen points since the late 1800s where excessive, passive concentration in public markets would have destroyed returns for 10 years or more. For instance, if you had invested a dollar in the US market in October 1929, you wouldn’t have recouped your dollar until 1954. Less well understood than the Great Depression is the equity drought of the late 1960s: the Dow Jones Industrial Average first rose above the 1,000 level in January 1966 but spent most of the next 16 years below that level. It didn’t rise above 1,000 for good until late 1982.
I used data from MacroTrends, sourced from Nobel laureate Robert Shiller, to identify seven periods since 1915 when a Dow Jones index-only passive investor would have been under water, in real inflation-adjusted terms, 10 years later in terms of capital appreciation (i.e., without reinvesting dividends, which would have added between 1.1% and about 5% annually depending on when you invest).
Any 10-year equity index investment during any of the following periods would have yielded negative returns (excluding dividends):
Between Q1 1915 and Q4 1916
1922 to early 1923
Mid-1924 to Jan 1926
The Great Depression … Although the market peaked on September 3, 1929 (and “crashed” on October 24 and again on October 29), any investment in the Dow after about August 1927 was a loser, up until early 1931.
Between mid-1959 and 1962
Between March 1963 to the end of 1976
Between November 1998 and August 2000
About a third of the time over the last 105 years, an investment strategy that solely relied on passive public equities would have generated negative 10-year capital gains.
Market data going back further is a bit sketchy, but it appears that we’ve had similar “equity droughts” where a passive US investor in the country’s major corporations would have generated negative returns for 10 years or more: around 1873, all of 1893, certainly in 1901, and then right before or during the Panic of 1907.
What Types of Macro Conditions Create These “Equity Droughts?”
Given that historical backdrop, one wonders what economic environments are conducive to a robust and growing stock market and which ones have generated these negative returns. It turns out that there are strongly predictive macroeconomic conditions when US public equities underperform. Figure 3 segments the last 90 years into six distinct periods, averaging about 15 years each. Each of these periods represents a different set of macroeconomic trends, and each had a unique set of risks for investors.
(Note that in the chart above, I have classified the 2000-2010 period as “deflation-like.” Consumer prices weren’t quite deflationary, as the CPI averaged about 1.3% from 2009 to 2015. But asset prices deflated sharply after late 2007. The median home price in the US declined by about 28% from Q2 2007 to Q1 2011. There were also significant dislocations in credit and a reduction in credit supply that mirrored what we would see in a deflationary environment.)
As you can see, stocks have led the way in only three of these seven periods, despite being the best overall category over the 90 years. These have been the low-inflation, high-growth periods of US history, which have prevailed while most of us learned how to become professional investors.
However, equities clearly underperformed in two “deflationary” periods. They also didn’t perform very well during the “inflation period” on a real / price-adjusted basis from 1966 to 1982. The S&P 500 returned little more than its dividend yield of 3.5% from the mid-1960s all the way until the late 1970s, on a price-adjusted basis. The worst of the stock market performance during this era came not when inflation peaked, but when it first spiked rapidly. From 1972 to 1973, inflation more than doubled from 6% to 12%. In those two years, the S&P 500 declined by a combined 40%. Inflation was higher in 1979 and 1980, topping out at 13.5%; by this time, the S&P 500 had returned to positive performance.
We saw something similar in the other much shorter inflation period in the US: 1946-1948. Just as WWII ended, a combination of money supply expansion, war-time debt purchases by the Fed, and supply chain disruptions caused a 24-month period of double-digit inflation. The CPI was at 2% in February of 1946 and then soared into the double digits before settling back at 2% by December 1948. The S&P 500 dropped by about 20% between June 1946 and October 1946, as inflation was spiking, and then slowly crawled its way back to the war-time peak by late 1949.
Historical CAPE Measures Flashing Red
Despite headwinds on growth and inflation building, none of this is priced into US equity valuations. As of November 25, 2021, the markets seem to be pricing in a continued, historically supportive macro environment. Nobel Prize-winning economist Robert Shiller wrote a book back in 2000 that introduced a measure called a cyclically adjusted price / earnings ratio, which compares current market cap to trailing 10-year, inflation-adjusted earnings.
By this CAPE ratio, the broad US S&P 500 is now at 40x historical cyclically adjusted earnings. That means that equity valuations by this measure are in the 96th percentile of all observations since 1900.
Historically, when valuations reach these levels, large cap equity returns from public markets over the 3-5 year horizon badly underperform the historical average return since 1900 of just over 10%.
How to Invest in 2022 and Beyond
If large cap equities in the US are indeed headed for a period of subpar returns (or an outright correction), then it makes sense that investors should diversify across asset classes. But diversify into what?
Traditionally, the answer was bonds. While that made sense in prior periods of deflation, the yield on the long bond (i.e., the on-the-run Treasury 30-year bond) sits today at a historical low of just under 1.8%, even while inflation is running at 7% and rising. Other options are commodities, precious metals, or today’s equivalent of “digital gold” – crypto. At times of high inflation, commodities and metals have provided a nice return and a hedge against inflation risk.
But there is another asset class that provides healthy, uncorrelated returns to public equities – venture capital.
It’s logical that venture returns should be correlated with public equity returns (since realized returns will be better if public valuations are robust), but over the past two years more and more data show that is not the case. At PVC in early 2020, we realized very quickly that our portfolio would not look like public markets for several reasons:
Unlike most public market sectors, our portfolio was very resilient to the COVID downturn.
Our SaaS and eCommerce companies generally benefited from the pandemic.
Many of our companies were able to raise additional financing rounds, which valued them higher even as the public markets were dropping.
Here is some additional evidence that the correlation between venture and large cap public equities is very low or even non-existent.
First, Invesco published a white paper exploring this question, called The Case For Venture Capital, and they produced this rather amazing graphic using data from Cambridge Associates and found no long-term correlation between venture capital and public equity returns (r = -0.06, which means no significant relationship). The analysis used realized and unrealized returns, from 1990-2014, which captured several different macroeconomic environments.
Second, an excellent piece from Abe Othman at AngelList Ventures in 2020 explored this question and came to the exact same conclusion. In Innovation Isn’t Correlated With Markets, Othman reached the same “zero correlation finding.” Othman studied the realized and unrealized returns on a monthly basis, from January 2015 to March 2020, comparing the NASDAQ Composite 100 Index to the returns from the AngelList portfolio of investments (before fees and carry), which is a seven-year-old portfolio that makes thousands of investments each year.
An obvious rebuttal is that it is unrealistic to expect simultaneous changes between public and private markets. One might expect a lag in results, given that public markets act and revalue companies quickly, whereas price changes are reflected only gradually by the private markets. However, Othman tested this hypothesis as well and found that even on a lagged basis there was no indication of a strong positive correlation.
Whether or not the correlation is actually zero, it is clear looking at the following chart that it is very low. According to Pitchbook’s annual VC report (which uses both realized and unrealized returns), venture returns over the past 10 years show consistent, double-digit net IRRs, which seem to have no relationship to large-cap public equities by vintage year. Venture has ridden almost completely on the performance of software and smaller cap companies, whereas the large cap indices are driven by financial services, energy, and retail, as well as technology.
The chart below shows the returns to a long-term investor in each of four categories since 2007. Rather than aggregating returns from all relevant vintages, vintage year IRRs are plotted from inception through March 31, 2021. This view allows readers to track various strategies raised in different economic environments, and to really compare and correlate performance.
So should investors consider venture capital as a way to diversify away from public equities? Yes, for a few reasons:
Public equities in the US have performed very well over most of the past 40 years, but that favorable backdrop is unlikely to continue.
Modern Portfolio Theory investors should seek to diversify returns across different asset classes, to reduce the risk of losses.
Based on an empirical review of recent returns using Pitchbook data, Cambridge Associates data, and from reports by Invesco and AngelList Ventures, the long-term correlation between venture capital returns and the market (NASDAQ and S&P 500) is very weak.
Venture is a long-term bet on innovation, software, and small cap stocks, whereas large public indexes depend largely on financial services, energy, health care, and retail, as well as technology.
Investors should look to alpha-producing venture capital to diversify risk across future market cycles.
Aman was the COO of 500 Startups, has been the CFO of Sonos, and led finance at PayPal. Before that, Aman worked at Lehman Brothers and McKinsey, majored in economics at Stanford, and earned a law degree from Harvard, so he is particularly good at dollar signs and clauses and commas.
Aman has more than 15 years of financial and operational experience from both private and public technology companies. He has been a member of the management teams at some of the most successful companies in the world, including PayPal, eBay, and Sonos.
Prior to PVC, Aman was the COOof 500 Startups, which during his tenure was the world’s most active VC firm, measured by the number of investments made. Aman managed 500’s global fundraising team, the seed accelerator team, and the Series A growth programs. He also managed the Investment Committee for the firm’s global funds ($500MAUM).
Aman led the strategy teams at both PayPal and eBay Marketplaces and served as the divisional CFO of eBay’s North American Marketplace business, which generated over $2B in revenues and nearly $1B in operating profit.
As CFO, Aman has guided his companies to over $1B in debt and equity financings from family offices, HNWIs, VC/PE funds, banks, and public markets.
CFA since 2000
Financial Analyst at Lehman Brothers, Associate at McKinsey
Taught Economics at Harvard University
JD, Harvard Law School
BA, Economics and Public Policy, Stanford University
PayPal Mafia: wrote the first draft of PayPal's S-1 in the winter of 2000.
CFO at two different unicorns: Sonos, Inc. (NASDAQ: SONO) and CAN Capital