Equity returns and expecting less in the 'new era'

By David Peartree The Daily Record Newswire Investors could do themselves a favor by expecting less. In the aftermath of a historic financial crisis, and still facing heaps of debt, both public and private, this era has been dubbed "The New Normal." The phrase was coined by Mohamed El-Erian, the co-chief investment officer at PIMCO, as a way to describe the likely foreseeable future of subpar economic growth in developed countries, persistently high unemployment, and market returns below historical norms. The idea is that those conditions will persist until the massive amounts of debt are paid down, written off or inflated away. We are in an era of de-leveraging, which has the potential to be volatile and frustrating to investors. If PIMCO is right, investors working with dated expectations of market returns are likely setting themselves up to be frustrated and to fall short of their investment goals. The long-term total average annual return from the U.S. stock market between 1926 and 2011 was 9.8 percent. Expectations for stock returns over the next 10 years are for something less than the historical norm. Here is a sampling of some prominent views. As you'll see, even for the more upbeat, optimism is not what it used to be. Vanguard's most recently published Economic and Investment Outlook projects both U.S. and global equity returns over the next 10 years to fall most likely in the 6 percent to 9 percent range. Not awful, but below the historical average. Jack Bogle, the now retired but still active founder of Vanguard, similarly expects 7 percent returns from U.S. stocks over the next 10 years or more. He views that as acceptable. Bogle was broadly right when he called for strong returns in the 1990s and subpar returns in the 2000s. The views of Vanguard and Bogle reflect what passes for optimism these days. Other respected names are less sanguine. Ibbotson Associates, well known for its investment analysis and research, forecasts less. "Long-term valuation metrics are consistent with scant total returns from U.S. equities over the next five to 10 years. As of Nov. 30, for instance, our primary valuation model, which produces expected returns that are similar to those of the well-known GMO model, was predicting an average annual real return of -3.4 percent for small-cap U. equities, and 0.2 percent for large-cap U.S. equities over the next five years." (Ibbotson Associates, Economic and Capital Markets Commentary, 2012) Having already endured one "lost decade," that's bracing stuff. The GMO model referred to by Ibbotson is put together by the investment advisory firm, GMO. GMO's 7-year forecast is for U.S. large cap stocks to return 0.8 percent, and less for U.S. small-cap stocks. The better performers are projected to be U.S. blue chip stocks and global stocks, with projected returns ranging from 3.8 percent to 5.6 percent. GMO's call in 2001 for next ten years was spot on as forecasts go. They called for the S&P 500 to return -1 percent. For the 10 years ending December 2011, it returned 0.4 percent. Other well-known names, John Hussman of Hussman Funds, and Rob Arnott, founder of the research firm Research Affiliates and also a PIMCO fund manager, project 10-year returns for U.S. stocks in the 4 percent to 5 percent range. It would be easy to dismiss these views are rubbish. After all, market predictions are notoriously flawed. However, a recent blog by the author of the highly regarded Buttonwood column, published by The Economist, endorses a more constructive view of the long-term versus short-term outlook. "There is very little that can be usefully said about the short-term outlook for markets but it does seem possible to make better-than-random statements about the long-term, based on the valuation of the asset concerned." (Buttonwood's notebook: "The long-term or reversion to the mean," Feb. 27) The Buttonwood blog goes on to point out the currently elevated value of the Shiller P/E ratio, a long-term measure of market value which this column has noted before. It is also a metric that most of the commentators noted above take into consideration in some form. Although not at the extreme levels it hit in 2000, the Shiller P/E is still somewhat above its historical average. In the early 2000s, after the dot.com bust, Jack Bogle spoke at gathering of investment advisors in Rochester. This author recalls that he opined that total returns for the U.S. market over the next decade would likely be no better than the mid-single digits. Coming off of the 1990s, this outlook was delivered as a hard dose of reality. The audience seemed to receive this outlook soberly, though some were undoubtedly dismissive. Even if Bogle turned out to be overly optimistic, he was broadly right. Stock returns for the 2000s were destined to be subpar because by the end of the 1990s, U.S. stocks were extremely overvalued. It is a sign of the times that today an outlook for mid- to high single digit returns for the coming decade no longer looks so bad, even to Bogle. Market forecasts are not predictions. They are statements of probabilities not certainties. Still, market valuations have a strong correlation with future returns and forecasts built around sound market valuations should be given serious consideration. Investors have no control over market returns, but they can shape their expectations to suit the likely outcomes. Save more and allocate smartly. ---------- David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625, or email david@worthconsidering.com. Published: Thu, Mar 22, 2012