Emmet Dupas III and Dylan Hoon
BridgeTower Media Newswires
Over the past 10 years, many investors have benefited from very good returns. As of Oct. 1, a 10-year investment in the S&P 500 index returned 103 percent, and an investment in a bond index (we can use the US Aggregate Bond Index) returned 47 percent reinvesting our dividends and coupons payments.
A basic 60/40 portfolio with 60 percent in the S&P 500 and 40 percent in the USAgg invested for 10 years starting Sept. 30, 2007 and rebalanced annually would have returned 85 percent. These numbers should make investors happy and we should remember that 2007 wasn’t exactly the most ideal starting time to measure portfolio performance. The great financial crisis put late 2000 investors behind the eight ball, but markets recovered and have been very good to investors.
If there is one lesson that we can glean by all those numbers, it is that despite short- term volatility in markets, it is important to evaluate our investment returns over a long-term horizon. Investing in the year 2008 was scary, but sitting here in 2017 things look much better. For retirees and people nearing retirement the pertinent question they face is, “What are the next 10 years going to look like?” Unfortunately, no one knows for sure, we don’t have a crystal ball and we can’t tell you what the global economy is going to look like in a decade.
What we can do is use the past to make plans for the future. Past performance cannot predict future returns and this article is no different; past performance is not going to tell us what the future holds. What we can do is “open up the hood” and look at what the drivers of those past returns have been.
Citing Research Affiliates, the three primary drivers of returns over the last 40 years have been dividends paid, real growth in dividends and rising valuation levels. If you read financial news, you have probably heard the term ‘elevated valuation levels.’ A recent paper by Research Affiliates, “The most dangerous (ubiquitous) shortcut in financial planning,” states that over the last 40 years valuation levels have contributed about a third of the S&P 500 total returns. As of Oct. 1, the price to earnings ratio (S&P Trailing PE ratio) stood at 25.14x with a long-term average of about 15x. Ten years ago, on October 1, 2007 it stood at 20.6x. PE ratios are mean reverting, which suggests that they should revert to their long-term averages, not increase indefinitely. Unless we get a similar expansion in PE multiples, the S&P 500 will lose one of its important drivers of historical returns.
All of this together suggests there are not as many tail winds for the S&P 500 going forward. There is a good chance the next 10 years won’t look as good the past 10 years. Therefore, we need to plan our retirement goals accordingly.
Moving on to US Aggregate Bond Index, we can look the primary factors that drive returns for bonds which are the coupon yield on a bond, capital returns from changes in yields and a risk premium for any bonds that are not treasuries. Bond prices work like a see-saw; as bond yields decrease the price of older bonds with higher yields increase. As of Sept. 29, the 10-year yield treasury yield was 2.34 percent, and 10 years ago, on September, 28th 2007 yields sat at 4.59 percent. Yields are not necessarily mean reverting like PE ratios. There are cases of sovereign yields going negative; however, it seems unlikely they could go into deep negative territory which could create a soft floor for yields.
This story is similar to the S&P 500 PE ratios; unless we get a similar environment in which interest rates continue to drop, bonds will lose an important driver of returns over the last 10 years. We need to plan our retirement goals accordingly.
Putting all of this together, the evidence isn’t dire. Stocks will probably still pay dividends, earnings are likely to grow and bonds will continue to make coupon payments. However, important contributors - PE expansion to the S&P500 and a falling interest rate environment for the U.S. - might not be as strong as they have been in the past. As prudent planners, we should incorporate reduced assumptions into our retirement plans and be cautious about our prospects and outlook. The investment environment is no longer as simple. Now more than ever, it is important to have tailored financial plans that fit your specific goals and can incorporate the unique challenges that investors face today.
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Emmett Dupas III is a wealth management advisor at Northwestern Mutual. Dylan Hoon is an investment assistant at the firm. The opinions expressed are those of Emmett Dupas and Dylan Hoon in this article. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance.
