Research Affiliates: Yesterday’s Gone

January 30, 2015

"Don't stop thinking about tomorrow … Yesterday's gone, yesterday's gone."
—Fleetwood Mac

Bill Clinton followed this anthem into the White House 20-plus years ago, at the start of an era that brought us commercialization of the World Wide Web, rapid productivity growth, and a historic bull market.1 The song also seems fitting as we kick off another new year, contemplate another Clinton presidential campaign, and develop our capital market return expectations following another long bull market.

We present here the first quarterly update of our 10-year expectations for asset class returns. Notice we say expectations and not forecasts. We put a "flux capacitor"2 on our Christmas list, but Santa failed to deliver, again. Without the ability to visit the future, we are left with our expectations based on economic theory and empirical evidence. Before we examine these expectations, let's start by taking a look at the history of asset class returns.

Yesterday's Returns
One hundred years ago the global capital markets looked much different than they do today. Many of the asset classes we now consider to be staples in our portfolios were either non-existent or just too difficult to trade. From a look-back perspective, the data on these markets is questionable at best and non-existent at worst. Therefore, for the purpose of examining long-term historical returns, we limit our analysis to U.S. stocks and bonds and the simple 60/40 portfolio of the two.3

Figure 1 shows that an investor in 1915, investing in the 60/40 portfolio, and reinvesting all cash flows for the next century, earned an annual nominal return of 8.4%, composed of 10.3% from equities and 5.6% from bonds. Not too shabby!

 

For a larger view, please click on the image above.

 

In fact, Table 1 shows that investing in the 60/40 portfolio over more recent periods, the last 50 or even 25 years, resulted in even better annualized nominal returns, with U.S. bonds picking up some of the slack from a slightly lower U.S. equity market return.

 

For a larger view, please click on the image above.

 

Initial Conditions
With such consistency over these long time horizons, it is tempting to extrapolate past returns into future expectations. Before doing so, however, we should compare the conditions of the past century, which provided strong tailwinds for financial markets, with today's environment. Table 2 shows valuation metrics for U.S. stocks and bonds at the outset of each of these investment periods. In both the long (100-year) and short (25-year) periods, P/E ratios were low and yields were moderate to high.

 

For a larger view, please click on the image above.

 

Notice that the 50-year period appears as an outlier. The equity P/E ratio was high, in the 18s, while the dividend yield was moderate to low, just below 3%, and bond yields were also moderate, just above 4%. Even starting from these conditions, the 60/40 portfolio returned 9% over the next 50 years. If 60/40 can flourish despite starting with a high equity multiple and a moderate bond yield, this mainstream portfolio must be a stalwart in all market environments, right?

Not so fast. Consider the first decade (1965–1974) after the start of the 50-year period, shown in Figure 2. Over this period, the 60/40 portfolio returned a measly 2.3% in nominal terms and a negative 2.8% in real terms. For that decade, equities and bonds returned 1% and 3.7%, respectively, while inflation averaged 5.2%. So, although the portfolio subsequently rebounded, the high multiple coupled with the low yield resulted in awful returns for the first decade. Today, multiples are even higher and yields even lower. We'll come back to this point later.

 

For a larger view, please click on the image above.

 

Let's also take a moment to reminisce about some of the changes to the business environment that have occurred over the last century. Henry Ford installed the first moving assembly line, indoor plumbing and home electrification became standard, women joined the work force, infant mortality rates declined dramatically in many parts of the world…. We could go on and on, but instead we leave it to you to take a few moments to reflect.

This is not to say that technological, social, and health-related advancements will not continue to occur over the next century.4 However, it is fair to pose a question about the marginal importance of future advancement relative to the past. Asked in a practical way, if you had to make a choice between indoor plumbing (from a hundred years ago) or your smart phone (from a decade ago), which one would you choose? Which had a larger impact on society as a whole? Can we expect the same financial tailwinds from future advancements? Only time will tell.

 

 

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