If you expect fabulous returns to continue, you’re likely to be disappointed. Look closely at the data and you’ll see why.
By William Baldwin, Senior Contributor
Emerging market stocks will beat U.S. stocks. Junk bonds will beat high-grade bonds. Inflation will be 2.5%.
Prognostications from the market seers. Big financial institutions put out what they call capital market assumptions. The experts are in close agreement about some things, such as the points about emerging markets, junk and inflation. They are all over the map on what you can expect from the richly priced U.S. stock market but in agreement that returns there will be rather less than what you’re used to.
Understand, first, what is meant by an expectation. It is not the prediction of a specific result, like who’s going to win the NCAA championship. It is the midpoint of a bell curve of probabilities. Uncertainty is built in.
In this exercise a financial firm’s purpose is not for its clients to time the market, an impossible task, but rather to let them make long-term plans. If you are banking on a great investment return to cover your retirement, you need to pay attention.
The most important revelations are about the potential returns from stocks. A naïve take on investing looks at past results—a 9.4% average annual real return over the past 10 years on U.S. stocks—and projects more of the same. But one of the reasons for the handsome past return is that the market’s average price-to-earnings ratio has gone from a modest level to an unusually high one.
What would it take for the market’s magnificent return of the past decade to repeat itself? An analyst at AQR Capital Management recently did the math. Even if earnings speed ahead at an unlikely 6% rate above inflation, he found, the market’s ratio of prices to earnings would have to reach an outlandish level never before seen, higher even than during the tech bubble of 2000. Could happen. Probably won’t.
Following here is a sampling of Wall Street forecasts, followed by a fine dissection of one method for estimating future stock returns. Throughout, the numbers are for real total returns, meaning with dividends included and inflation subtracted. There’s no allowance for taxes or portfolio management costs.
U.S. STOCKS
Annual returns from large U.S. companies, as projected by various experts.
There’s quite a dispersion of opinion on this topic.
These forecasts vary in their time horizons (7 or 10 years for some, nothing specified for others, 20 years for Fidelity). They vary somewhat in how recently they have been updated and in what market segment is covered, but in most cases it’s aligned with the S&P 500 index of large companies.
The entry at the top is from a lone Morningstar analyst, John Rekenthaler, included because this outlier injects a note of optimism and because he makes a good case for his conclusion. The collective earnings of corporations will plod ahead at the 2% growth rate of the economy, he says in a recent essay. Shareholders will gain another 3.5% from a combination of share buy-backs and cash dividends. He assumes that price-to-earnings ratios, while high by historical standards, will stay where they are.
The firm at the bottom, founded under the name Grantham, Mayo, Van Otterloo, is quite the sourpuss. Its reasoning: P/E ratios are destined to revert to historic norms, and when they do they will drag stock prices down. This Boston money manager’s pessimism has cost it a lot of clients in recent years. But every now and then GMO is spectacularly right. It called the tech bubble and before that the absurdity in the Japanese stock market of the late 1980s.
Research Affiliates is a Newport Beach, California money manager known for value-tilted portfolios (more Exxon Mobil, less Nvidia). To arrive at its number it adds to a 1.4% dividend yield a 2.6% growth in earnings per share offset by a shrinkage in P/E ratios of like amount.
The 3.3% entry in the middle comes from the market’s earnings yield, which is the inverse of the P/E. How an earnings yield drives returns is explained at the end of this survey.
HIGH-GRADE BONDS
Experts’ expectations for total returns on U.S. fixed income, exclusive of junk.
Fidelity’s seers are in a safe spot, since their horizon is 20 years and the return on inflation-protected Treasuries over that period is known in advance: just under 2.1%.
The other firms are describing nearer-term results from an aggregate bond universe that includes some long-term bonds and a lot of bonds that will be redeemed and replaced. For the aggregate, a change in expected inflation or real interest rates could push a portfolio’s return away from yields seen today. Schwab is expecting a pleasant surprise in rates, GMO an…