Future Expected Returns of Stocks and Bonds Are Poor

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.