John Nicola explains why mean reversion in equity returns should have advisors looking at total returns
The minor market correction and significant volatility that defined Q1 of 2025 for investors has largely been laid at the feet of President Donald Trump. The US President’s embrace of gilded-age trade policy and apparent willingness to endure economic and market pullbacks to achieve a trade reset and bring manufacturing jobs back to the US has been the core reason cited for an incredibly uncertain period on equity markets. John Nicola, however, sees deeper issues at work that might make advisors want to reconsider their portfolio allocations.
Nicola is the Chairman, CEO, and CIO of Nicola Wealth. He sees the ongoing downturn as a “self-induced recession” on the part of the US administration. He does not, however, subscribe to the idea that if a more stable policy from Washington emerges equity markets will resume their growth trajectory. He highlighted some fundamental aspects of equity market performance and valuations that might give advisors pause about maintaining a bias towards price appreciation over total returns in their asset allocation.
“If you look at US equity markets, the Shiller PE ratio is at its second highest level in history, higher than the Great Depression and only slightly below the dot com bubble. You can look at that and see markets are expensive and therefore a correction or a bear market should be in the cards at some point. We haven’t yet seen that, we’ve seen a correction of around eight to ten per cent,” Nicola says. “Even if you don’t get a recession, there’s an earnings rationale that comes back… You can see where the PE ratios are, and you can see what the probability of earning superior returns is.
“This would be a time to reduce your exposure to equity, notwithstanding Trump. Trump is an interesting side show, and he might accelerate things, but we’re seeing now what inevitably had to happen. So, your five-year return from December of last year when the PE ratio peaked is probably three to five per cent per year. If you’re in that environment, you should ask what the other options are.”
Nicola’s prediction aligns roughly with a Goldman Sachs outlook which predicted three per cent annualized returns on the S&P 500 over the next decade. He describes that underperformance as simply “mean reversion” following several years of outsized growth. Nevertheless, he says that many advisors and their clients are having tough conversations about returns over the past few years, where their returns of around 9.5 per cent feel like underperformance next to double digit returns from balanced funds. His response is to frame asset allocation somewhat differently, framing a total returns strategy as a means of behaving ‘like the house.’
Casinos win, he explains, by a pure numbers game. Their slight edge in probabilities across all games means they will come out ahead provided a certain number of games are played. When the temptation for some investors is to go big on risk assets, Nicola offers a counterpoint example in the maple eight pension funds. Those funds’ global reputation is built more on the consistency of their positive returns than their single-year outperformances. Looking at an expensive an risky US equity market, Nicola believes that allocating to strategies with more of a total returns focus can help maintain the consistent positive returns that investors actually need.
Nicola cites the example of a few real estate subsectors as evidence for this approach. He notes that US industrial real estate has been effectively flat to negative for the past two years, despite paying high rents. Because of recent negative performance, though, Nicola says that many investors will remain biased against these flatter asset classes.
He notes, for example, a residential property that his firm recently closed a deal on. The portfolio of low-rise luxury apartments were bought at a very reasonable rate from a developer that had run out of money just as these units were being completed and occupied. Nicola explains that even though the units are now generating rents for his clients, the NAV of the portfolio will drop in the next year as transfer costs and purchase reporting is baked into their value. By focusing on total returns, however, Nicola says that clients will see the value of developing what is effectively a private pension plan with income generated by assets like these apartments, and a laundry-list of other income generating assets like dividend paying stocks.
“What I care about is a sustainability, and then ultimately, the growth of the cash flow being generated by the asset I have in hand. That's my first focus,” Nicola says. “The sooner I receive that cash flow, the less risk I have on the table. If I buy that ten million [dollar] portfolio, and in the first year I get $500,000 of income. Well, now I'm into it for nine and a half million. These are ways of building wealth over time. Even if a client approaches us for the first time at age 60, they've got a decent chance of a 30 year runway. Nothing is short-term.”
