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The Science of Hitting
The Science of Hitting
Articles (469) 

'Expected Returns Into a Lower Orbit'

Some thoughts on what markets offer over the coming years

April 04, 2018 | About:

At the end of 2017, Vanguard published their annual market outlook. I don’t remember hearing it discussed at the time, so I thought I’d go through the capital markets section and share some of the key takeaways, along with some commentary of my own.

Let’s start with a summary of their market expectations:

“For 2018 and beyond, our investment outlook is one of higher risks and lower returns. Elevated valuations, low volatility, and secularly low bond yields are unlikely to be allies for robust financial market returns over the next five years. Downside risks are more elevated in the equity market than in the bond market, even with higher-than-expected inflation.”

I think those are reasonable conclusions. It's hard to escape the gravitation pull of low bond yields and elevated valuations. In both cases, I think investors should be prepared for lower nominal rates of return than what they’ve historically attained from these asset classes. Whether that happens slowly (an extended period of lower returns) or quickly (a market correction) is anybody's guess.

“Based on our 'fair-value' stock valuation metrics, the ten-year outlook for global equities has deteriorated a bit and is now centered in the 4.5% - 6.5% range. Expected returns for the U.S. stock market are lower than those for international markets, underscoring the benefits of global equity strategies in the face of lower expected returns. The projected odds of a U.S. market correction are higher than they have been historically.”

Again, that sounds reasonable to me. We’ve seen years of outsized equity returns (at least relative to long-term trends), but the good times can only last so long. Using the cyclically adjusted P/E (CAPE), U.S. equities ended 2017 in the 90th or 95th percentile of their historic valuation range. Whether we move towards the 80th or 100th percentile is anybody’s guess; it seems to me it would not be prudent to make your base case a continued move higher. As this chart from Goldman Sachs shows, the S&P 500 is trading around the 90th percentile (relative to historic valuations) on a number of other metrics as well. Again, I think you would have a tough time arguing that the "appropriate" assumption from here is even more extreme valuations.

“Our expected return outlook for U.S. equities over the next decade is centered in the 3% - 5% range, in stark contrast to the 10% annualized return generated over the last 30 years.”

That’s a tight range, but I think it’s directionally correct (when pressed, I tend to say low-to-mid single-digit annualized returns). Vanguard assumes a roughly three percentage point annual headwind to U.S. equity returns from a contraction in valuations. In the summary statistics for their Vanguard Capital Markets Model (VCMM) simulations, the authors showed that we’ll need to end up above the 95th percentile (on their 10,000 simulations) for returns over the coming decade to match U.S. equity returns over the past 30 years. Good luck!

If you accept their argument on lower forward rates of return, then the following chart is worth considering. It plots forecasted returns (using data from GMO) relative to subsequent three-year drawdowns. The title of the chart says it all – “low forecast returns run the risk of deep drawdowns”:

Vanguard believes International equities (from a U.S. investor’s perspective) will perform slightly better, with projected returns of 5.5-7.5% per annum over the coming decade.

“As highlighted in previous sections, elevated equity valuations, low rates, and compressed spreads have pulled the market’s efficient frontier of expected returns into a lower orbit.”

Lower return expectations (relative to historic results) are the norm, not the exception. All-in, it looks like the next 10 years will be less generous (and possibly much less generous) to investors than what we’ve experienced over the past 10 years.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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