I've visited some of you over the past few weeks, and many of you were wondering about our 2016 view and where we see things heading. Let me start by saying that you will never hear me share a forecast of where I think the market will be heading over the next twelve months. The truth is, my guess is as good as yours, and the odds are we will both be wrong, so it's a futile exercise, in my opinion. There are very few points in time, at points of market extremes in optimism and pessimism, where one can say with some confidence that the odds are that the markets will head in one direction or another, and even then, a twelve-month forecast period may be too short. But let us try to look at the current economic and market environment and try to think about the longer term.
The US economy continues to perform relatively well, and whilst there are downside risks because of a slower global economy, there are also upside "risks" like a stronger housing recovery and stronger consumer spending from lower energy prices. Europe remains weak, but I'm optimistic that we will see it recover. China continues to be the wild card, and the risks there continue to increase in my opinion, but whether things will get a lot worse from here remains to be seen.
Long term, I'm still a believer in the Chinese consumer, and the government's efforts to transform the economy from investment-driven to consumption-driven is showing some promise, but that will take years to make a material impact. In the near term, a weaker China continues to hold down the global economy and commodity prices, which in turn holds down other markets, especially emerging markets. We finally got a rate increase from the Federal Reserve, so we can technically say that the US dollar is in a tightening cycle versus a eurozone that is still in an easing cycle - though 25 basis points does not make a trend. With this backdrop, it's remarkable to see that the financial markets don't seem to price in all these risks. While stocks are inexpensive relative to other asset classes, especially bonds, they are not cheap in an absolute sense. This environment causes us to remain cautious and defensive in what we do.
One of the simplest and, remarkably most accurate, methods for forecasting future returns comes from John Bogle, founder of the Vanguard Group. Bogle advocates using three variables only to predict stock returns over the next ten years: dividend yields, estimated earnings growth rates, and estimated changes in the market P/E ratio based on how much higher or lower than long-term averages it is. I will perform this on the S&P 500, because the data set is longer and more readily available, and then I will discuss how I think the MSCI World Index will perform relative to it. First, dividends. The current dividend yield on the S&P 500 is 2.2%. Second is earnings growth. This is harder to estimate, but given that real earnings growth rate has been between 1.7% and 2.6% and inflation should run at 2-3%, I think it's reasonable to expect that nominal growth rate between 3.5% and 5.5%. Add this to the dividend yield, and we get a return of 5.7-7.7% before the impact of changes in the P/E ratio - which is where it gets really tricky. If we use the current P/E ratio of 18x and assume it declines to the 60-year median of just under 17x, we arrive at a total return for the S&P 500 of between 4.7% and 6.5% per annum. If we use the Shiller Cyclically Adjusted PE (CAPE) instead, we get a return of between 0.8% and 2.56%. Adjusting the Shiller CAPE by removing 2008 trough earnings of $16.80 per share (but keeping 2009's, which were still down 42% from the 2006 peaks) reduces the current CAPE to 22.8 and brings the estimated returns to 1.8% to 3.5%. In short, 4-5% per annum is probably the best one can hope for from the S&P 500 over the next ten years. The picture looks a little better for the MSCI World Index, where the valuation is lower and the dividend yield is higher. Using a similar calculation, I estimate annualized returns over the next ten years at 6.5-7.5%. So, the picture for overall markets isn't very encouraging, but I think we can do better than that, and here's why.
Market volatility has come down since I wrote last at the end of August, but is still higher than where it was the past few years, and I expect it to remain this way. Take a look at the following chart, which shows the CBOE S&P Volatility Index (the "Vix") since 1990. The yellow line is the historical median, and you can see that we're pretty much at normal levels right now. (Update: the VIX has jumped to 25 since this paragraph was written.) The low levels of volatility since 2012 were abnormal. This is good news for us, as value strategies like ours tend to underperform in periods of very low volatility.
(Source: Mayar Capital, Bloomberg)
The following chart looks at the relative annualized return of the MSCI World Value Index compared to the MSCI World Growth Index. Over the past ten years, the value index has underperformed growth by 3.5% per annum - an all-time low - compared to a historical median outperformance of 1.2% per annum. Using a different index produces different magnitudes but a similar relative picture. The lesson to take from this chart is that the odds are heavily in the favor of value stocks doing better than the overall stock market. Not necessarily this year or next year, but over the next decade. In an environment of ultra-low or negative interest rates on fixed income, low cap rates on real estate and high valuations in private equity and venture capital, value stocks seem poised to outperform other investments.
(Source: Mayar Capital, Bloomberg)
First published in Mayar Fund's Letter to Partners - December 2015 (portions have been redacted)