http://www.wsj.com/articles/three-ways-investors-can-see-the-future-1467684120
Three Ways Investors Can See the
Future
Forecasting long-term returns is
doable, with caveats
By JOHN COUMARIANOS
July 4, 2016 10:02 p.m. ET
“It’s tough to make predictions, especially
about the future,” goes the saying, often attributed to the late baseball
legend Yogi Berra (and many others).
Year after year, Wall Street
analysts trying to forecast quarterly corporate profits keep proving the saying
is right. Their record is unenviable.
Yet small investors can make
forecasts about long-term investment returns in stocks and bonds that at least
are based on decades of market data. Such forecasts aren’t infallible, but they
can help investors estimate whether they’re saving enough to retire or send
children to college.
Here are three ways investors can
get an understanding of what markets are likely to deliver—maybe not precisely,
but closer than many investors might think.
A longer-view P/E
One method for forecasting
long-term returns comes from Nobel laureate and Yale University professor Robert Shiller.
It’s based on price/earnings ratios, but it uses more data than the one year of
profits that many forecasts rely on.
Because profits have a pronounced
cycle, making one year’s earnings potentially misleading, Prof. Shiller
compares current stock prices to 10-year average earnings, after adjusting them
for inflation, to get an idea of where stocks are headed.
The so-called Shiller P/E has averaged about 17 since
1870. It’s above 25 now, implying below-average future returns, assuming the
ratio tends back toward the historical average.
Hedge-fund manager Clifford
Asness has shown
that from 1926 through 2012, on average, investing when the market has a
below-average Shiller P/E produces higher returns than investing when it has an
above-average Shiller P/E.
There are exceptions, when
investing at low valuations produced poor returns and investing at high
valuations produced strong returns; no metric is perfectly predictive. But the
odds aren’t on your side for good returns when valuations are high.
According to Mr. Asness’s 2012
paper, on average, stocks have produced a minuscule 0.50% annualized real
return for the next decade when starting from a point where the Shiller P/E was
above 25.
That’s an average, so the next 10
years won’t necessarily be that bad. But it’s worth remembering that the
S&P 500 index has returned a decidedly subpar 4.1% on a compounded
annualized basis from 2000—when the market in January was at a record high
Shiller P/E of 44—through 2015.
Three steps
Vanguard founder Jack Bogle
outlined a three-step process for forecasting share prices over the next decade
in an interview with fund tracker Morningstar
Inc. last year. It starts with dividend yields, which have accounted for a
significant part of historical stock returns. The S&P 500 index currently
gives an investor about 2% in dividend yield.
Second, Mr. Bogle factors in the
historic earnings growth rate, which is close to 5% annually for the 100 years
through 2014. That plus the dividend yield pushes the prospective return for an
investment today in a fund that tracks the S&P 500 to nearly 7% annualized
over 10 years.
Last, Mr. Bogle incorporates an
estimate of what multiple of earnings investors will pay to own stocks in the
future. He figures the current multiple of 20 for the S&P 500 (based on one
year of earnings) will decline over the next few years to its historical norm
in the midteens, That leads him to reduce the prospective 7% annualized return
from dividends and earnings growth to 4%—much lower than the 10% stocks have
delivered over the past century.
Bonds
Bond forecasting is simple,
according to Mr. Bogle. He says bonds’ current yield to maturity has been a
good predictor of their returns for nearly every 10-year-period since 1906.
The bad news is that the current
yield of the 10-year Treasury note, for instance, at 1.446%, might not be
enough to maintain an investor’s purchasing power over the next decade,
especially if the Federal Reserve achieves its target of 2% inflation.
Moreover, investors can’t easily find government bonds abroad to provide better
protection against inflation. During a recent webcast, Los Angeles bond house
DoubleLine Capital showed the jarring statistic that roughly $8 trillion of the
world’s sovereign bonds currently provide negative yields, making them a
guaranteed money-losing proposition. After the Brexit, that number has
increased to $11.7 trillion.
Investors willing to take on some
additional risk can achieve a little more than 3% annualized returns by owning
high-quality corporate bonds—based on the current 3.07% yield to maturity of
the iShares iBoxx $ Investment Grade
Corporate Bond ETF (LQD). That should maintain purchasing power,
barely.
Mr. Coumarianos, a former
Morningstar analyst, is a writer in Laguna Hills, Calif. He can be reached at reports@wsj.com.
