Each year, I put my head on the chopping block and publish a 30-year forecast for global stock and bond market returns. This forecast is used to create long-term asset allocation strategies for our clients.
It's a terribly imprecise exercise because no one can know how financial markets will perform in the future. There are just too many variables and too many unknowns. Yet here it is. So why do I risk professional suicide each year with an expected return forecast that's bound to be wrong? I do it because it's necessary.
A Necessary Exercise
Despite insurmountable head winds, we must plan. This means making assumptions about future risk and return even though we know the limitations of our assumptions. The idea of a well-constructed portfolio is to match current assets to future liabilities while controlling for risk. Yet the only known in this equation is the current asset level.
Estimates must be made about everything else; future deposits and withdrawals, asset class risk and returns, inflation, time horizon, liquidity, taxes, etc.
Antti Ilmanen writes in his comprehensive book Expected Returns: An Investor's Guide to Harvesting Market Returns: "We should humbly recognize the limits of our understanding. Realized returns are dominated by randomness, structural uncertainty, and rare events. Expected returns are unobservable, at best, estimated with noise. Any observed return predictability is mild, possibly spurious, and rarely robust."
We don't know much about the future, but we do know that others have opinions and that those opinions are reflected in market prices. We're also keenly aware that return expectations reflected in market prices are often far off the mark.
An asset class with recent high returns will draw the attention of many new investors who bid prices up on the expectation that returns will rise even higher. However, higher prices have to be supported with fundamentals, which fail to materialize. Prices then begin to fall, investors stampede out and returns collapse far below their historic average.
Recall the Nikkei in the 1980s, tech stocks in the 1990s, home prices in the 2000s and perhaps long-term bonds this decade.
In mid-March, a Zero Coupon Treasury Bond maturing in 2044 was priced to yield 2.43 percent. Since zero coupon bonds pay no interest, 2.43 percent is exactly what an investor will earn on their investment through the year 2044.
Does 2.43 percent tell us anything about interest rates except this is what investors in that bond expect to earn in the future? Will interest rates remain low for the next three decades? We can't know the answers from today's yield.
Forecasting is arduous, and we can't say much about the future. What we can say is that owning stocks is riskier than owning bonds and bonds are riskier than holding cash. Therefore, stocks should return more than bonds and bonds should return more than cash in the long run—most of the time.
Assumptions In The Forecast
Our 30-year total return forecast relies on five primary assumptions about financial market risk and return:
- Interest income, dividend yield, rents and other cash flows are an important part of total return
- Price volatility contains information about the trade-off between risk and return in the long term
- Investor perception of risk can change over time and this can affect current valuation and future expected returns
- Monetary policy changes investor preference for taking risk
- Fiscal policy and other political factors also change investor preference for taking risk
Don't Fight The Fed
One problem with assessing the returns of free markets is that they are never truly free. Artificial forces created by government policy are always in play. These factors can move capital among asset classes in a less than efficient manner.
Moreover, "monetary policy actions tend to influence economic activity and prices with a lag," according to a recent Federal Open Market Committee (FOMC) Statement on Longer-Run Goals and Monetary Policy Strategy. There is never true equilibrium in the system.
The U.S. and other developed nations have been practicing a policy of financial repression, whereby interest rates are held below the inflation rate. This helps government leaders finance spending and stimulate their economies, but it hurts the returns on fixed-income investments and pushes capital into riskier assets to find higher yield.
The result is an increase in the valuation of riskier assets, which decreases expected long-term returns.
It's widely anticipated that the FOMC will begin raising interest rates this year or early next year. In contrast, other central banks are going in the opposite direction by lowering interest rates through quantitative easing and even driving rates into negative territory.
All of this matters when forecasting long-term returns.
There are two sets of return expectations in this report: One set is a real return based on a pre-inflation estimate; the other is a nominal return expectation that includes an inflation estimate.
Both are pretax. We include both returns because most people conceptualize investment returns nominally and pretax even though the only performance that really matters is the real return after tax.
Our inflation estimate comes directly from the FOMC long-term inflation target. This number is updated periodically and was recently outlined in the FOMC's statement on goals and strategy cited earlier, as amended effective Jan. 27, 2015. The longer-run goal for inflation, as published by the FOMC, is 2.0 percent annually.
We're not there. Over the last 12 months (ending January 2015), the Consumer Price Index for All Urban Consumers (CPI- U) decreased 0.1 percent before seasonal adjustment, according to the Bureau of Labor Statistics. A more stable core CPI number that excludes food and energy was up 1.6 percent over the same period.
We show expected U.S. bond returns under the assumption that interest rates will become more normalized over the next five years. This means investors will eventually earn a real return on Treasury securities again. We anticipate real returns over the next 30 years to be lower than the historic average because financial repression will be slow to abate.
Current Valuations Matter
U.S. stocks are anticipated to return slightly lower than their historical average. The U.S. equity market is trading at a moderately high valuation level, but not extraordinarily high. Stock prices have increased 35 percent since their peak in 2007, while corporate earnings have increased by only 25 percent, according to S&P Dow Jones Indices.
The outsized gain in prices has pushed the S&P 500 price-to-earnings ratio (PE) to about 20 times trailing 12-month earnings.
Investors should be prepared for lower-than-average returns when asset prices are higher than average. It doesn't matter if the asset is stocks with high PE or bonds with low yield; the outcome is the same. Higher prices today mean lower long-term returns. There is no free lunch on Wall Street.
The flip side of PE is earnings. An increase in earnings would lower PE. Earnings come from a combination of sale growth, productivity gains, lower borrowing costs, lower taxes and other factors.
Corporate earnings for the economy in aggregate are roughly linked to GDP growth. The FOMC is forecasting longer-run real GDP growth to be 2.0 to 2.3 percent, according to its March 2015 economic projections. This rate has been lowered in recent forecasts.
The strong dollar is softening this number in the short term because U.S. goods and services have become less competitive globally. On the flip side, a strong dollar and cheap energy prices help boost growth in overseas economies, which helps equity markets overseas.
Asset Class Forecasts
Given the backdrop of a strong dollar, continued low interest rates in the U.S. and moderate GDP growth, our long-term total return estimate for large-cap U.S. stock investments is 5.0 percent. Smaller companies have a higher expected return because they have higher risk.
REIT expectations have been lowered slightly because the asset class has attracted an abundance of capital as investors seek higher current income.
International equities have become more attractive relative to U.S. equities. Developed markets have underperformed the U.S. equity market for more than 15 years, and their valuations are lower. In addition, a strong dollar, quantitative easing in Europe and Japan, and low oil prices have added to the attractiveness.
The following table is provided for informational purposes only and not intended to be used for short-term market timing. This forecast always attempts to err on the conservative side. It's wise to expect and plan for lower returns and then be pleasantly surprised if the forecast is too low.
|Our 30-Year Return Estimate of Bonds, Stocks & REITs|
|ASSET CLASSES||BEFORE INFLATION RETURNS||RETURNS WITH 2% INFLATION||RISK* ESTIMATE|
|Government-Backed Fixed Income (Normalized)|
|U.S. Treasury bills (1-month maturity)||0.1||2.1||2|
|10-Yr US Treasury notes||1.9||3.9||7|
|20-Yr US Treasury bonds||2.5||4.5||8|
|30-year Treasury Inflation-Protected Securities (TIPS)||2.6||4.6||9|
|10-Yr Tax-free municipal (A-rated)||1.6||3.6||7|
|Corporate & Emerging Market Fixed Income|
|10-Yr Investment-grade corporate (AAA-BBB)||2.6||4.6||9|
|20-Yr Investment-grade corporate (AAA-BBB)||3.3||5.3||10|
|10-Yr High-yield corporate (BB-B)||4||6||15|
|Foreign government bonds (unhedged)||2.4||4.4||9|
|US Common Equity & REITs|
|US Large-cap stocks||5||7||19|
|US Small-cap stocks||5.3||7.3||22|
|US Small-value stocks||5.8||7.8||26|
|US Real Estate Investment Trusts (REITs)||4.8||6.8||19|
|International Equity (Unhedged)|
|Developed countries small company||5.7||7.7||23|
|Developed countries small value companies||6.2||8.2||27|
|All emerging markets including frontier countries||7||9||30|
*The estimate of risk is the estimated standard deviation of annual returns. The 30-year forecast data is presented on an annualized compounded total return basis. All interest and dividends are reinvested. The table is provided for general informational purposes only. Neither Richard Ferri nor Portfolio Solutions LLC warranties the accuracy of the forecast, nor should the forecast be deemed to constitute financial advice or an investment recommendation.
For a full list of relevant disclosures, click here. Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.