Investing in a low-return world

Summary: Total returns from the US stock market over the next decade could be significantly lower than the last one, but investing in gold, commodities and real estate may not be a solution.

John Bogle, the founder of Vanguard Funds, gave a seminal speech in June 2003 in which he laid down a framework for estimating future long-term returns from the stock market. Stock market returns over the next ten years, he argued, will be determined by three elements:

- By how much will earnings grow between now and then?
- What value will the market place on those earnings a decade from now?
- How much will an investor receive in dividends along the way?

Bogle called these factors investment return and speculative return. Dividend payments and companies' earnings are investment returns. Changes in the value the market places on earnings - the market's P/E ratio - are speculative returns. Bogle argued that for a rough estimate of future market returns, you can simply add the three numbers together. (You should really multiply earnings growth by the change in P/E, but there's not much difference in practice.) The dividend yield plus earnings growth plus the change in the market's P/E ratio will give you total future returns.

Bogle showed that the US stock market returned an average of 10.4% annually in each decade between 1900 and 2000, of which 9.8 percentage points came from earnings growth and dividends, and 0.6 percentage points from an increase in the market's P/E ratio.

Speculative returns fluctuate far more than investment returns, though. The poor performance of the 70s, when total annual returns were just 5.9%, was driven by a collapse of the market's P/E ratio that sliced 7.5% off returns each year. The bull market of the 80s and 90s, when total annual returns were 17.3% and 17.8% respectively, was driven by a dramatic rise in the market's P/E ratio that added 7.7% annually to returns in the 80s and 7.2% in the 90s.

At the time he gave his speech in 2003, Bogle predicted that the stock market would return only 7.5% over the next decade. Earnings would grow by about 6%, dividends would add 2%, and the market's P/E ratio would contract slightly. Bogle argued that the market's P/E ratio tends to revert to its historical mean level, which is about 15.5 since 1935. You can read Bogle's speech here; I've also put some links to some of his books on the right hand side of this page, which are excellent for investment professionals and retail investors alike.

When Bogle gave his speech in June 2003, the S&P 500 was trading at about 19 times operating earnings (its multiple of reported earnings would have been higher). Nine months later, in March 2004, the S&P 500 was trading at about 18 times 2004 estimated operating earnings, 22 times reported earnings, and 23 times "core" earnings, a new measure that Standard & Poor believes is a more accurate measure of corporate profits.

Can we then expect total stock market returns for the next decade to be about 7.5%? Not according to John Mauldin.

John Mauldin's new book, Bull's Eye Investing - Targeting Real Returns in a Smoke and Mirrors Market, asks where the stock market will be in ten years' time, and how you should invest as a result of that. It's potentially important, not so much because Mauldin disagrees with Bogle's estimate of future returns, but because his investment recommendations are so different. (You can find a link to the book on the right of this page.)

In the first half of the book, Mauldin sets out to prove that in ten years' time the US stock market will likely be no higher than it is now, and possibly significantly lower. (Mauldin's book follows a recent spate of books that predict impending financial declines for the US, the most prominent of which I've also linked to on the right of this page.) Like Bogle, Mauldin uses the framework of estimating dividends and earnings growth - Bogle's investment return - and the value the market will place on those future earnings - Bogle's speculative return. But he differs sharply with Bogle because he thinks the market's P/E ratio will contract, and earnings growth will be below its historical average.

First, on the market's P/E. Mauldin thinks that the market's P/E ratio will fall over the next decade for four reasons:

  1. Secular bull markets have never started from times when the market's P/E ratio was as high as it is today.
  2. The market is currently overvalued compared to its historical average using multiple measures, and will likely revert to its mean valuation. (This is also the current view of money manager Jeremy Granthan, whose excellent quarterly letters and asset class forecasts you can access via the link on The Market Resource Page.)
  3. The risk premium is currently too low, given recent corporate scandals and geopolitical risk. The risk premium is the return investors expect from risky assets (stocks) over and above the return on assets which bear no principal risk (US Treasury bills). A rise in the risk premium would mean that investors would have to expect higher returns in the future, which means present values would have to fall. In other words, the market's P/E ratio would have to fall.
  4. In the past, the market's P/E ratio has fallen when inflation has risen. The market's P/E ratio also falls when an economy slips into deflation. Given the US economy's current inflation rate (close to zero), there's therefore nowhere to go that would result in a higher P/E ratio for the market.

Next, Mauldin provides four reasons why corporate earnings will grow more slowly than their historical rate of 5.7% to 6%:

  1. Companies' future reported earnings will be depressed by the adoption of stricter accounting standards, the expensing of options, and higher pension costs.
  2. The retirement of the baby-boomers in the US and the aging of the populations of Europe, China and the ex-Soviet bloc will depress demand for products and services. It will also dramatically raise government spending on health care and pensions and thereby push up tax rates, further hampering economic growth.
  3. The US budget deficit and current account deficit will lead to a 30% to 40% decline in the dollar and weak economic growth.
  4. Innovation works in cycles, resulting in periods of fast growth followed by overinvestmend and slower growth. Mauldin thinks these cycles last about 55 years, and we're entering the slow phase now.

In sum, expect P/E ratios to fall and earnings growth to disappoint. Add in dividend yields far below their historic average, and total market returns for the next decade look bad.

How bad, exactly? Well, Mauldin suggests that P/E ratios could fall from their current average (18-23, depending on how you calculate earnings) to below 10. Somewhat offset by mediocre earnings growth and 2% dividends annually, Mauldin thinks that net returns for the broad stock market over the next decade will probably be zero to slightly negative. Mauldin's estimate is similar to Jeremy Grantham's most current seven year forecast of minus two percent annualized returns from US large cap and small cap stocks, but a lot worse than Bogle's June 2003 estimate of 7.5% annual returns.

In some places in his book, Mauldin suggests that total returns will be far worse. He refers to "the long term secular bear market with the slow economic growth I predict for the rest of the decade", and predicts that the Nasdaq, with its inflated valuations and lack of dividends, will plummet, ending up lower than the S&P 500. That's quite a fall, given that at the time I write this the S&P 500 is at about 1,100 and the Nasdaq's at 1,925.

Given this depressing prognosis, how does Mauldin think you should invest for the next decade?

With total returns from the US stock market expected to be zero or negative over the next decade, what's an investor to do? Mauldin makes the following suggestions:

  • Buy value stocks. "Buying deep value for the long term is a strategy that works in all types of markets", Mauldin says. Value stocks have histically outperformed growth stocks, so you should buy stocks when their price is below the present value of their future earnings. If you can't pick value stocks (or, I should add, calculate present-discounted-values...) then buy equity mutual funds run by value-oriented managers. Mauldin recommends that you buy stocks with low P/E ratios, and wait until the market's overall P/E is below 10-12 to buy index funds. (His approach sometimes mirrors and sometimes differs from other advocates of value-stock investing. I've linked to some of the best books on the topic on the right.)
  • Buy dividend yielding stocks, because "a stock with a 6 percent dividend rate will roughly double your portfolio every 14 years after taxes, even if there is no growth in the stock or growth in the dividend".
  • Buy only short term bonds, since interest rates are heading up. If you can, choose foreign bonds, since the dollar will fall by another 30-40%. Buy the bonds directly and hold them to maturity in a laddered bond portfolio. Don't buy bond funds, because you'll take a hit to your principle as rates rise.
  • Buy gold, because "the general direction of the price of gold is up, and will be so until the dollar stabilizes". Even better, buy gold stocks since they are leveraged to the price of gold, but make sure you know which companies' stocks to pick.
  • Invest in commodities, through commodity pools and global macro funds. Like gold, commodity prices should benefit from the falling dollar.
  • Buy real estate by borrowing money while interest rates are low, and servicing the debt by renting out the property. "Inflation will eventually be your friend", by pushing up the value of your property while reducing the real value of your debt.

Do Mauldin's investment recommendations make sense?

John Mauldin's recommendation to buy stocks, gold and real estate, and to own only short-term bonds is based on a strong assumption: that the primary risk over the next decade is inflation.

When prices are rising, investors want to own real assets and borrow nominal assets. If you own property, its price should rise with inflation. If you own stocks, corporate earnings should increase as companies raise the prices they charge. And because the US dollar becomes less valuable as prices rise, gold should do well. In an inflationary environment, bonds do badly: their principal value is eroded over time, and their interest payments decrease in real terms as prices rise. For exactly that reason, it makes sense to borrow money when inflation is rising: the amount you'll have to repay in real terms will be less than when you took the loan. That's why Mauldin thinks that borrowing money - a nominal asset - to purchase property - a real asset - makes sense for the next decade.

But what if deflation takes hold and prices actually fall? Then all of this is reversed. If you hold cash in a money market account, it gets more valuable by the day. But the prices of gold and property decline, and corporate earnings fall as companies charge lower prices for their goods and services. In a deflationary environment you want to own nominal assets and avoid real assets. The home-run investment before deflation sets in is long-term bonds, because the principal becomes more valuable as prices fall, while interest payments are higher than from short-term bonds. The worst investment in a deflationary environment would be to borrow money to buy property. Deflation would boost the value of the debt (the nominal asset) and slice the nominal value of the property (the real asset), so you'd lose on both ends of the trade.

So a lot hinges on Mauldin's assumption that inflation is more likely than deflation over the next decade. Is that assumption correct? That's far from clear. It seems to me that the outlook for the US economy over the next decade - whether it will face inflation, deflation or price stability - will be determined by five factors:

  1. The twin deficits. The federal bugdet deficit and the US current account deficit are both potentially inflationary. The current account deficit could lead to a declining dollar, which would raise import prices. And when governments face large and intractable budget deficits, one "solution" is to inflate away the value of the government's outstanding debt.
  2. Accelerating economic growth due to liberalization of markets. China, India and the ex-Soviet bloc are rapidly liberalizing their economies. That should boost economic growth in those countries and the countries they trade with. Rising demand from those countries should push up the price of oil and commodities, and potentially boost demand for US products. Impact? Inflationary in the short run. But what about the long run? If energy and commodity prices are pushed up by rising demand from China and other developing countries, the impact on US aggregate demand will be negative. (Rising prices due to external forces are equivalent to a tax on an economy.) Will overall prices in the US rise in line with commodity prices, or will the negative economic impact lead to falling prices and lower margins? Not clear.
  3. Increasing global competition. The opening of the low-cost labor markets of China, India and Eastern Europe has occurred at the same time that improvements in communications and global supply chain management have made outsourcing easier than ever. This should push down the price of labor (which accounts for the majority of production costs) in developed countries. Unless Western countries quickly retrain and re-educate their workforces, the period of structural change could be highly deflationary.
  4. The aging of the US, European and Russian populations. More on that in a moment.
  5. Monetary and fiscal policy. Deflation could inflict serious damage on the US economy due to high household and corporate debt relative to historical levels. Fed governors have stated that they will do everything they can to prevent deflation.

How will these factors play out? Not clear. The forces of inflation versus deflation and the impact of globalization within that have been the subject of intense debate. As the cyclical upswing in the US economy takes hold and the employment data improve, the short-term risk of deflation seems to be receding. But the deflationary forces of globalization and aging are secular, not cyclical, and won't disappear due to a recovery in the US economy. Demography is particularly important, so we'll look at that in more detail now.

The problem of global aging is particularly important for investors, and is becoming more urgent. In 2006, the first of the American "baby-boomers", born in 1946, will reach their 60th birthdays, the earliest legal retirement age. Then, in 2011, they'll be eligable for full retirement benefits.

The impending increase in government benefits payments caused by the retirement of the baby-boomers is occuring at the same time the US is running an unprecendented budget deficit. Think-tanks and policy makers have therefore begun to ask some tough questions:

  • What will be the impact on the federal budget deficit of the increase in social security and medicare payments?
  • Will tax rates have to rise to pay for these benefits?
  • Will a balooning budget deficit push up long-term interest rates?
  • Can retirees rest assured that their benefits won't be cut?

Fed Chairman Alan Greenspan has raised the public policy issues in speeches and testimony to Congress with increasing frequency lately. He's expressed concern about the budget deficit, but has avoided calling for tax increases or even a reversal of recent tax cuts. Instead, he advocates reducing future benefit payments, partly through the adoption of a new way to calculate the price index that would cut the future value of index-linked benefits.

The result of this debate has been that much of the discussion about global aging has focused on benefit payments, taxes and the budget deficit, and how these factors will impact retirees and workers over future decades. Because rising deficits have historically led to inflation, viewing the global aging issue primarily from the tax and budget deficit perspective has led people to the conclusion that global aging is an inflation problem.

Laurence Kotlikoff and Scott Burns in their book The Coming Generational Storm, for example, paint a picture of aging global populations and then write that:

"The United States is doing all the things that mark an economy soon to be wracked by inflation and a weak currency."

And of course, they specifically mention the large and growing budget deficit. It won't surprise you to hear that Kotlikoff & Burns therefore provide the following investment recommendations:
  1. Buy gold.
  2. Buy real estate.
  3. Buy inflation-protected government bonds (TIPs).

But the assumption that global aging will result in inflation - even given the growing budget deficit - is questionable. First, as Alan Greenspan realizes, most goverment obligations to retirees are index-linked, even if most current government debt is non-index linked. If governments print money to fund their deficits, their future obligations won't go away. Second, the retirement of the baby-boomers could have a strongly deflationary effect.

In Global Aging and Financial Markets, published by the Center for Strategic and International Studies, author Robert England discusses the possibility that as retirees withdraw money from their savings and pension fund outflows exceed inflows, the resulting sales of equities will massively depress stock prices. Others have discussed the possibility that house prices could decline as retirees move into smaller houses after their children leave home and they reduce their living expenses. And in countries that face population declines, such as Japan, Italy, Germany and Spain, demand for housing will fall.

In two other books, The Great Boom Ahead by Harry Dent and a rather sensationalist short follow-up by Daniel Arnold called The Great Bust Ahead, the authors argue that a reduction in the number of 45 to 55 year olds over the next decade will depress aggregate spending in the US.

These effects - falling equity prices, potentially falling house prices and reduced aggregate demand - are strongly deflationary. Yet Mauldin accepts Kotlikoff & Burn's assertion that population aging will lead to inflation, and adopts their recommendations to buy gold and real estate. Even Jonathan Clements, who writes an excellent personal finance column for the Wall Street Journal, repeated the recommendation to buy real estate by putting money into your own home, based on the assumption that inflation and taxes will both rise due to the aging problem.

Now, don't get me wrong: I'm not coming down on the side of deflation in this debate. However, adopting the assumption that the US faces rising inflation over the next decade without sufficient justification, and investing accordingly in property, gold and other real assets seems premature and risky.

Consider these points:

  • Japan has been hit by the population aging problem earlier than other countries, and has experienced deflation and significant declines in equity and property prices.
  • "Gold is a wonderful diversifier, but like any pure commodity that generates no economic return, and whose entire return is based on price speculation, it carries enormous risk". That's a quote from Jack Bogle.
  • House prices in the US and UK are at historical highs relative to incomes, and have been rising at a rapid rate due to low interest rate mortgage financing. As interest rates rise - particularly if real interest rates are driven up by government borrowing - property prices could take a hit. If they return to historical multiples of average incomes, the decline could be dramatic.

So I think we should approach Mauldin's recommendation to buy value stocks, gold and real estate with caution. If inflation rules, he'll be right. But if deflation rules, these asset classes could prove to be money losers.