Today’s investors may have drawn the proverbial “short straw.” From an investment perspective, they are confronting what might be considered a “perfect storm” creating strong head winds against higher expected returns. We’ll begin by discussing the three main factors conspiring against them, then analyze some of the options investors might employ to combat this problem.
Equity Valuations Are High
As I write this, the CAPE 10 on the S&P 500 is roughly 26.3. In a November 2012 paper, “An Old Friend: The Stock Market’s Shiller PE,” Cliff Asness of AQR Capital found that when the P/E 10 was above 25.1, the real return over the following 10 years averaged just 0.5%, virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills.
The poor average returns—the best 10-year real return was 6.3%, while the worst 10-year real return was -6.1%—were a result of what might be called a “reversion to mean” for valuations.
That said, to estimate future returns using the CAPE 10 metric, you first calculate the earnings yield (E/P)—the inverse of the Shiller CAPE ratio—and get 3.8%. However, because the Shiller PE is based on lagged 10-year earnings, we need to make an adjustment because real earnings grow over the long term. I suggest using 2% as an estimate of future real earnings growth.
To make that adjustment, we multiply the 3.8% earnings yield by 1.1 (0.02 x 5), producing an estimated real return to stocks of about 4.2%, or a full 3 percentage points below the real return of 7.2% from 1926 through 2014. (We multiply by five because a 10-year average figure lags current earnings by five years.)
If we use the Federal Reserve Bank of Philadelphia’s Survey of Professional Economists forecast of 2% for future inflation, that produces an estimated nominal return of just 6.2%, 3.9 percentage points below the historical return of 10.1%.
Bond Yields Are Low
The Federal Reserve’s zero-interest-rate policy has driven both real and nominal yields down to historically very low levels. For example, since 1926, the real return on five-year Treasury bonds has been about 2.3%. As I write this, the nominal yield on the five-year Treasury is about 1.7%. Using the Federal Reserve Bank of Philadelphia’s inflation forecast produces an estimated real return of -0.3%.
