Returns Can Disappoint for a Long Time

Investing can disappoint for long periods of time.  There is no rule that says that over the next 10, 20, 30 years or more, stocks have to return 10%, bonds have to return 7.5% (while also being a strong diversifier for stock risk), and inflation has to come in at a tame 2-3%.  All of us, from the investment industry down to individuals, have a rosy picture of how fruitful investing can be.  The last 30-40 years really were a golden era for investment returns.  Declining inflation and interest rates gave bonds the strongest tailwind ever, while also providing a boost to stocks.  Corporate profits nearly doubled the share of the economic pie relative to workers.  In 1970, corporate profits represented 4.9% of GDP, while today the number is 9.5%, pushing up earnings (and stock prices) across the entire economy.  Labor force expansion, driven by women entering the workforce from the 1970s on, pushed up economic growth in a way that literally can’t be replicated in the future.  Massive increases in computing power along with improving global supply chains increased productivity.  Lastly, corporate tax rates have been falling (the statutory rate was nearly 50% in the 1970s), providing more cash for shareholders.

Almost all of these trends are reversing, or are at least at or near their apex, and are unlikely to be repeated.  Despite an economy with 4% unemployment, 3% GDP growth, and a Federal Reserve desperate to get inflation going again, inflation still remains below 2%.  The 10 year US Treasury bond yielded over 12% at the end of the 1970s, a number that’s only 2.4% today.  You could make the argument that corporate profits as a share of GDP can continue to grow, but it’s difficult to see a big increase without major civil unrest.  With the baby boomer generation retiring, labor force participation is far likelier to shrink than to grow.  Globalization is stagnating or reversing, and there’s a legitimate debate over how much productivity growth all that computing power actually gave us.  But hey, a corporate tax cut was just enacted, so who knows?

Adding to the headwinds, current valuations in stocks, bonds, and pretty much any other asset class suggest poor long-term returns.  Valuation is often a poor tool for determining expected return in the short run, but in the long run, valuation matters quite a bit.  According to Antti Ilmanen from AQR, everything is rich versus its own history, because everything has been pulled down by the common discount rate.  Risky assets are priced much more aggressively.

Valuations are a bit strange.  Historically, short term returns have very limited correlation to valuations.  In the medium term (5-15 years), valuations matter a lot and have a very high correlation to future returns.  Over the long term, growth in the economy has historically overwhelmed buying at high valuations (although returns are still highly correlated to valuations at the purchase) and provided adequate returns.

The problem, of course, also resides with us.  Even with 20 or more years, do you have the stomach for long periods of poor returns without pulling money out of the market?  Only if you stick it out and remain invested can you claim the long-run returns.  Trading in and out of the market will surely cause underperformance.  Take a look at the below charts.  These are the after-inflation, or real, rolling returns for both stocks (the S&P 500 index) and bonds (the Barclays Aggregate index).  Both have had long periods of disappointment.

Of course, the fact that everyone is saying returns will be lower in the future may mean that they won’t be lower!  Unfortunately, we can’t count on that saving us.  When doing your planning, you should use very conservative numbers (although even conservative returns can be optimistic!).  Using historical average returns is a highly suspect way of planning.  Average returns do not factor in sequence of return risk and periods of high volatility can really drive that risk.  Average returns also do not account for the fact that you’re likely to both take money out and add money into your accounts.  Stated historic returns are returns that a dollar that was invested at the beginning of the period, and held through end of the period, would have achieved.  In reality, this is simply unrealistic.  Life tends to get in the way of well-designed plans.

Yes, Valuations are Really Bad

US stocks currently trade at the highest quartile in both price/earnings ratio (how much you pay for a dollars’ worth of earnings) and the lowest quartile for dividend yield.  Below are the average 10 year returns based on buying in at certain valuation points:

Not surprisingly, buying in at lower price/earnings ratios and high dividend yields result in better returns.  The current price/earnings is over 22 and the current dividend yield is 1.9%.  Both point to fairly poor 10 year returns in the 3-5% range.  There have been arguments made that the current low interest rates will lead to higher valuations.  Unfortunately, history doesn’t play out this way.  We’ve seen low rates in the past (for example, the 10 year Treasury yield was similar in the 1950s to today) and the price/earnings ratio and dividend yields were both much more attractive then.  In particular, price/earnings ratios were far more attractive as recently as 2012 and 2013.  Interest rates tell us very little about where valuations “should be”.  Another argument, one with perhaps more merit, is that earnings quality is much better today than in previous years and hence worth paying more for.  This may be true (although it may not), but even in that case, it’s likely worth paying only marginally more, not 3-5 multiples more.

Unfortunately, fixed income doesn’t look much better.  Current yields are in the 2nd percentile since the 1950s, meaning that 98% of the time, yields have been higher than today.  Much as the price/earnings ratio and the dividend yield are pretty good indicators of future returns, bond yields are pretty good indicators of future bond returns.  Below are the average 10 year returns based on different yield starting points and more importantly, yield per unit of duration (duration is a measure of bond sensitivity to interest rate changes, so you can think of this as yield per unit of risk):

The Barclays Aggregate yield is currently 2.6%, and the yield per unit of duration is a whopping .43%.  Again, both point to very subpar returns from here on out.

Further, the diversification benefit from bonds has been substantially reduced with low yields.  Bond prices are inversely related to interest rates.  Interest rates need to be able to decline in order for bonds to rally when stocks decline.  The lowest yield recorded for the Barclays Aggregate is 1.6%, which with a duration of six implies a potential increase of only ~6% if yields decline by 1%.  If stocks drop, that’s not much of a buffer.  Sure, the Barclays Aggregate could go lower than a 1.6% yield, but remember that the Barclays Aggregate includes corporate bonds and mortgages, in addition to US Treasury bonds.  It’s awfully tough to see a path to a sub 1.5% yield.

What to Do

Unfortunately, there are no easy answers.  This will be a massive adjustment and disappointment for everyone.  We all need to be prepared to make hard choices.  No longer can we count on the market to bail us out of our poor decisions.  Frugality and earning a higher income so that you have a high savings rate matter far more today than in the past.

The first step is to focus on what you can control.  Save more and continue to invest.  Yes, you will have to delay current consumption in favor of building yourself a financial fortress, but the alternative is far worse.  Focus on asset allocation and risk control.  Costs for your investments (management fees, trading costs, tax costs) are more impactful in lower return environments – basis points (.01% increments) count more now than when returns are 10% or higher.  Be prepared for longer hold periods if you want to invest in risky assets like stocks or real estate.  Longer hold periods are less susceptible to high market valuations, as natural growth through time overwhelms paying a high price.  Also, pick investments that better match your goals, instead of blindly putting money in a stock/bond portfolio regardless of the price.  If you have a 20-30 year timeframe, keep putting money in stocks.  If you have a shorter term need, you’re probably better off keeping it in cash (a money market or T-Bills) or short duration investment grade bonds.

Rethinking your investment process and core assumptions will also be beneficial.  Much of current investment methodology is based on the experience of the last 30-40 years.  Much of that experience may no longer be relevant, so you’ll need to reexamine your assumptions.  Income durability becomes a more pertinent piece of the total return pie.  If income returns 3% and the total return is 4% instead of 9%, there’s a big difference in the importance of dividends and bond coupons relative to stock and bond prices.  Valuation metrics are far more deterministic to price performance than to income performance.

You’ll also need to learn to be more opportunistic and nimble, and expand your horizons beyond traditional asset classes.  Even in low return environments, unique opportunities can be found.  Look to areas where capital is fleeing and focus your research here.  For example, the Barclays Aggregate bond index only includes US Treasuries, investment-grade corporate bonds, and mortgages.  Perhaps asset-backed loans and senior bank loans could be attractive.  What about some of the new, asset-backed lending platforms like YieldStreet or PeerStreet?  Factor strategies in stocks can be interesting, particularly strategies such as momentum and trend following, which can do well regardless of the market direction.  Heck, even value investing may actually come back into favor at some point!  Factor investing is easier and cheaper than ever, with ETFs available for almost any strategy.

Over the long run, stocks are still likely to outperform bonds, although both will likely disappoint relative to the last few decades.  Be prepared and adjust your expectations.  You’ll need to save more and be smarter with your investments.  Focusing on what you can control and being opportunistic can put you in a position to do better than most.

Keep building my friends.

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