August 5, 2016
By Steve Blumenthal
“There is no panacea for the low returns implied by asset valuations today. Anyone suggesting differently is either fooling themselves or trying to fool you. But piling into the assets that have been the biggest help to portfolios over the past several years, as tempting as it may be, is probably an even worse idea than it usually is.”
– Ben Inker, GMO
Today, let’s take a look at the most recent market valuations and what they are telling us about forward returns over the next ten years. But keep in the back of your mind that you can get pretty close on seven and ten-year return probabilities but it is a coin flip on what the equity returns will be over next number of months.
We do know that the insatiable demand for stocks with above average yield is causing valuations to diverge materially from historical norms. This may continue. In a recent State Street poll, investors were asked what their returns expectations are for the next five years and beyond for real estate, commodities, equities and bonds.
Answer: 10.9% for real estate, 8.1% for commodities, 10% for equities and 5.5% for bonds
10% for equities? I find myself wondering who spiked their punch bowl.
I previously wrote that in December 1999, GMO’s seven-year forward return forecast predicted a negative annualized real (after inflation) return for stocks. They took a lot of heat but they were proven right.
In the intro quote above, Ben noted, “There is no panacea for the low returns implied by asset valuations today. Anyone suggesting differently is either fooling themselves or trying to fool you.” Amen brother.
Let’s go back a few years to another point in time when valuations were stretched and investors were “fooling themselves.” Note the two red arrows in the next chart.
Here is that same chart after inflation is calculated in.
Source: DShort Advisors Perspectives
We find ourselves at a position much like the late 1990s. After a 17-year bull market, valuations were simply too high. Everyone was racing into technology. The market may go higher but what are the implications over the next five, ten and fifteen years — both before and after inflation. And boy, does the Fed wish to create inflation.
As of June 30, 2016, GMO’s seven-year real (after inflation) return forecast for equities is even more negative than it was in 1999. Imagine a negative compounded -2.7% per year over the coming seven years.
Let’s go back to that State Street survey: 10% for equities? 5.5% for bonds?
$100,000 compounded at 10% per year for ten years equals approximately $259,000. That is almost 2.6 times on your money. GMO uses a seven year forecast but I also like ten-year forward return forecasts so let’s consider several investment choices (bets) over the coming ten years.
Maybe you’re not in the 10% return camp? Maybe you are not as bearish as GMO but believe 10% is unlikely. Let’s call it the “hope so” camp so for simplicity’s sake, let’s halve the potential return to 5%. That means that by the end of June 2026, you look back and find that your $100,000 grew to $163,000 or 1.63 times your initial investment.
Finally, let’s consider the GMO outcome. While their return prediction is for a -2.70% after inflation (the actual market return less inflation), let’s assume that inflation is 2.70% and thus makes the nominal (before inflation is subtracted out) return 0%.
Overall, inflation is important because your money has to grow in a way that covers the rising costs of things you need. If inflation is 2% per year, you need a return of 2% on your investments just to keep pace. But I digress.
Three bets to consider: 10%, 5% or 0%.
- #1 State Street Poll (pays you 2.6 to 1) – your $100,000 grows to $260,000
- #2 Hope So (pays 1.63 to 1) – your $100,000 grows to $163,000
- #3 GMO (pays 1 to 1) – your $100,000 grows to $100,000
But before you place your bet, think of GMO as “the house” in the casino. By this I mean they’ve done a great job at calculating the odds of winning. They’ve been posting their forecast metrics out for many years and their accuracy rate is impressive at a high 0.93 (1.0 is a perfect correlation while -1.0 is a perfect non-correlation). No guarantee, of course. Just saying that in the geek world in which I live, 0.93 is really good. Put that calculation in the back of your mind as you place your chips on the table.
Hold on just one additional second. Added in is one last option for you to consider. My thinking is that sometime within the next several years, like times in the past, a correction will take place that will reset the opportunity deck and make forward equity returns good again. Think about the opportunity you had to buy equities in the summer of 2002 or late 2008. So add into the mix option #4:
- #4 GMO/Patience/Defense/Opportunity (pays 1 to 1 over two years then 2 to 1 over the remaining eight years: for overall odds of 2.14 to 1) – your $100,000 grows to $214,000 *(I took 0% over the next two years and then 10% for the remaining eight)
Ok – Step to the table and place your bet. My heart and wallet is hoping for #1 but to me the odds favor #4. That’s my bet. And I hope that my portfolio arrives at the opportunity with principal preserved. That’s the goal. A recession or rising interest rates or both will most certainly hit the popular 60-40 portfolio mix hard. No guarantees.
Early each month, I like to run through the latest valuation measures. Let’s do that today. We’ll take a look at various measures, including my favorite “Median PE”. We’ll also look to see what valuations might be telling us about 10-year forward return probabilities.
If you didn’t take note, go back and look at the chart above that shows the performance of the DJIA, S&P 500 and NASDAQ since 2000. The Dow performed best but take that 56.2% and divide it by 16.5 years. That equates to a compounded annualized return of approximately 3% (before inflation is calculated in). Also, take a look at that 1.8% gain in the NASDAQ. Recall that most of the money was flooding into technology stocks in the late 90s. 1.8% divided by 16.5 years is not so good and that is before inflation is considered.
If you are a CMG client, please note that we may be positioned in high yield bonds, government bonds, equities or seek the safety of treasury bills depending on an investment factor called “momentum.” For example, if you are invested in our CMG Opportunistic All Asset Strategy, you’ll note that we’ve seen technology ETFs showing strong relative price