Oct 2017 by Joe Burns
Developing reasonable expectations for future returns in any asset class is difficult, including traditional equity and fixed income. That said, investors and advisors must have some degree of confidence on what future performance might be across all aspects of a diversified portfolio.
Both stocks and bonds have several sources of return, which over the long-term provide a reasonable guide to future performance. For equities, one must consider valuation and growth: valuation in terms of margin and multiple expansion, and growth in the context of potential earnings and dividend appreciation. Bonds are a bit more straightforward, as investors must consider the credit worthiness of an issuing entity (the likelihood of a bond maturing at par), along with the coupon payment as a form of current income. From a macro point of view, capital flows and technical factors can dominate the price movements of both bonds and equities over reasonable periods.
The following two charts reflect (i) the underlying components of equity returns, as presented in a recent GMO article referencing the forward-looking return expectations of the S&P 500 Index, and (ii) the expansion of the Federal Reserve balance sheet since the onset of Quantitative Easing.
Over the long-term, the growth in earnings and dividends for S&P 500 constituent companies has been relatively steady over the past 50 years. The more variable components of return relate to valuation, specifically multiple (price/earnings) and margin (income/revenue) expansion, or contraction. It has widely understood that current equity valuations are at extreme levels, with the cyclically-adjusted P/E ratio of the SPX currently trading above 30, which had only occurred in the late 1920’s and 1990’s prior to the most significant equity declines in U.S. market history. Assuming valuation levels ultimately revert to their historic norms over the next 7 years, the expected return for the benchmark is negative 3.9% (annualized) prospectively, as per the above analysis. While this seems excessive, it is interesting to note that the 7-year return for the S&P 500 Index through March 2009 was negative 3.2%.
Anticipating negative returns for equities over the next 7 years is difficult to fathom, especially after the S&P 500 Index has generated an annualized 18% return since 2009. But it does provide a frame of reference. More importantly, investors should consider the drivers of equity returns, expectations for future growth and valuation, along with any macro factors that have contributed to this exponential rise in equity (and bond) prices. The most significant macro factor, in our view, has been the unprecedented liquidity infusion by Central Banks via the quantitative easing mechanisms. As seen in the above chart on the right, the Fed has increased their balance sheet from approximately $500bil to $4,500bil since 2009.
This $4T increase was the result of the Fed purchasing enormous amounts of treasury and mortgage bonds, which fueled the markets with liquidity and drove bond prices higher and higher (and correspondingly, bond yields lower and lower). This in turn made the earnings yield of equities appear that much more attractive, as compared to a 10-year UST yield of sub-2%. Today, as the Fed continues to raise interest rates and has just recently initiated the balance sheet run-off, this substantial driver of asset price appreciation will no longer be the primary engine of bond and equity markets. While both asset classes benefited tremendously from this multi-year tailwind, so too might stocks and bonds struggle as liquidity gets slowly and steadily pulled out of the financial system. This will create not only problems from a (lack of) diversification standpoint, but will impact the most significant return driver in most portfolios: global equity market appreciation. The importance of portfolio diversification and return generation increases daily, moving further away from traditional stocks and bonds.