(This article was originally posted in our marketplace service)
The amount of capital that has been flowing into dividend and dividend-focused equity strategies has been tremendous. All in an effort to find yield given the low interest rates on the fixed income side of diversified portfolios. Media and pundits have focused on the "bubble" in bonds given that interest rates "have to rise." We believe the bubble is on the equity side as investors who normally would not accept equity-type risks are forced to shift their asset allocations due to the Fed's zero-interest rate policy.
Valuations on utilities, telecom and consumer staples stocks that have decent yields are at very high levels. In a recent marketplace post, we noted what we believe is a bubble forming in low-volatility stocks which are typically characterized by dividend-paying low-beta names. The XLP (the Consumer Staples Select Sector SPDR ETF) has a 22x trailing P/E ratio. This is not composed of fast-growing companies that typically constitute the technology or biotech spaces. These are companies like Proctor and Gamble (NYSE:PG), Coca-Cola (NYSE:KO), and Altria (NYSE:MO). We highly recommend fellow author "Early Retiree Reality" April 2, 2016 piece on the subject who notes the rise in PEG ratios among these names as growth slows and P/Es rise.
The blowup in the MLP space, which housed a significant number of investors that would otherwise have been in fixed income if rates were 'normal,' has aided the demand for dividend-payers. Those investors got into "safe" MLPs that were "uncorrelated" to the price of oil. Well, we know how that turned out, with some MLPs down over 50% in a year. So much for safe!
Many of those investors have turned to "safe" dividend paying stocks like utilities and consumer staples. You know, the one's that won't go down much if the market corrects? These herd investors have bid up these dividend and dividend-growing names. YTD, the SPDR Dividend ETF (NYSEARCA:SDY) is up an astronomical 14.03% compared to the 4.56% for the broader S&P 500.
Pension funds and other institutional players are taking the same actions piling into risk in order to make specific hurdles rates that put their plans into balance with forecasted liabilities. Most pension plans assume 7.5% growth in their assets, something that we believe is a pipe dream over the next decade.
Investors are between a rock and a hard place, in our opinion, and should be content with lower returns over the next several years. Investment returns are highly dependent on the start date of the data analysis. We are now on month 87 of the bull market whereas, depending on how you parse the data, the typical bull market averages roughly 59 months. We are definitely long in the tooth to this equity run. Future returns will be highly dependent on what happens during the next recessionary environment which typically realizes an S&P 500 decline by over one-third.
We see 3-5 year equity returns in the low single digits and possibly much lower if a recession materials. Volatility is likely to be higher than average with standard deviations in the high-teens towards 20% given the geopolitical threats escalating, weaker economic growth especially in the emerging markets, and turmoil in Europe with the Brexit vote.
Future equity returns are highly dependent on the valuations current on the start date of the analysis. As of mid-June, 2016, we have had a strong bull market and valuations are now at 24.1x according to the Shiller P/E10 ratio. This compares to just 7.4x in 1982, 15x in 1993, and 14.7x in 2008. John Hussman's work on the subject has been exhaustive.
From this analysis:
The chart above presents our best estimate of prospective 12-year total returns on a conventional portfolio mix of 60% stocks, 30% Treasury bonds, and 10% Treasury bills. The 12-year horizon is used because that's the point where the autocorrelation profile of valuations reaches zero (see Valuations Not Only Mean-Revert; They Mean-Invert). The chart below uses the ratio of nonfinancial market capitalization to corporate gross value-added to estimate prospective S&P 500 total returns. This measure has a 93% correlation with subsequent market returns at this horizon, significantly exceeding that of the Fed Model, price/forward operating earnings, the Shiller P/E, Tobin's Q, and apples-to-oranges measures such as the ratio of the S&P 500 to scaled profits from the National Income and Products Accounts (NIPA). Conventional investment portfolios - meaning most of those held by reasonably long-horizon, growth-focused investors - are presently likely to return just 1.6% annually over the coming 12-year period.
As a side note, we continue to see the same reliable signal of bubble peaks that appeared in 1929, 2000, and 2007: the emergence of novel valuation measures encouraging investors to believe that current extremes are still reasonable. This practice repeats because, to use John Kenneth Galbraith's timeless phrase, "as in all periods of speculation, men sought not to be persuaded by the reality of things but to find excuses for escaping into the new world of fantasy." While I'm not a great adherent of the Shiller cyclically-adjusted P/E (NYSEARCA:CAPE), I periodically cite it since it's a widely followed and reasonably useful measure. To the extent the Shiller P/E can be improved, the best way to do so isn't to use a different profits measure in the denominator; it's to correct for the variability of the implied profit margin that even the Shiller P/E demonstrates over economic cycles (see the Hussman May 5, 2014 market comment). Using normalized profit margins (which significantly increases the relationship to actual subsequent market returns across history), the current CAPE would not be just 25, but a much more obscene 34, more than double the historical norm.
Is Fixed Income Risky Today?
For years now, we have been hearing that the bond market is in a bubble, that interest rates HAVE to go up, and that inflation is going to crush the fixed income investor. Well, that has yet to occur and recent economic data has shown that the likelihood of quick rising interest rates is extremely low. The Fed originally roadmapped four hikes to the fed funds rate this year and four hikes in 2017 for a total of 200 bps of raises (2.25% by year-end 2017). We have had a total of one and it appears unlikely that we get even two this year. If we had to make a directional bet, we think the fed funds goes to zero before 1.00%.
The chart below shows the fed funds futures or expected rates over the next several years. This data is as of March 31, 2016. Since then we have had the horrible May jobs report which decimated fed funds expectations for the next several months.
Current yields are typically indicative of some sort of global economic stress. However, there are several other factors that are contributing to low yields, including foreign buyers escaping negative yields. This is likely to suppress long-term rates on the yield curve as most of Europe as well as Japan are experiencing negative rates on their government bonds. The 2s/10s spreads are down to approximately 90 bps, which has often typified a red flag signal for investors. But with the Fed attempting to, or at least signally upward pressure on the short-end and market dynamics (supply and demand) on the long-end of the curve pressuring yields, further flattening appears likely.
Since 1976, the Barclays US Aggregate Bond Index (formerly the Lehman US Agg) has had just three down years, with the largest drawdown being 1994 when it fell 2.92%. In 2013, the last time the index was down, it fell 2.02%. The index is actually fairly stable averaging roughly 5% over the last fifteen years with a standard deviation of just 3.2%. (Sharpe Ratio of 1.2). Of course, with interest rates where they are, replicating that kind of performance with low volatility will be extremely difficult.
One of the primary concerns for fixed income investors is that interest rates will rise and the returns of bonds will have a substantial headwind. While rising rates are indeed a headwind, it is typically the swiftness of the rise that can hurt bonds. From 1940 through 1980, a period of time when interest rates rose fairly substantially overall from 2.5% to 11.5%, the average annual return for the US Agg was 3.4% with the worst annual return being -3.2%.
In 1994, fed funds rose by 270 bps which led to the decline in the Agg of 2.9%. But from 2004-2007, interest rates rose from 1% to 5.25% but the bond index rose over 3.5% per year. We see no scenario where the fed funds rate will rise by that measure over the next four years. As we noted above, our probability scenarios call for rates back at zero before they reach 1.25%.
More Compelling Risk-Returns
We do have a fairly dour view of the markets in general today. As we suggested, equity values are being inflated by the Fed and fixed income offers extremely low yields meaning forecasted returns of a diversified portfolio are likely to be low- to at best, mid-single digits. Here is Morgan Stanley's recent assessment for the S&P 500:
(Source: Morgan Stanley)
How does it all end for us? Unfortunately, it is unclear. If stronger growth and eventually inflation doesn't materialize soon, the Fed may turn to attempting stronger inflationary tactics like real money printing instead of credit creation. Otherwise, deflation becomes even more prevalent creating a more calamitous economic environment for investors.
To us, the probability of an inflationary environment, the kind that catches the market severely off-guard and forces the Fed's hand to raise rates much faster than anticipated, is extremely low. We see the current slow-grind environment as much more probabilistic whereby interest rates stay low, and probably meander lower with GDP at sub-2% to negative 1%. The chance of a deflationary environment, one where we see a marked deceleration in inflation and inflation expectations, to us is a more likely outcome than an unexpected inflationary scenario.
Our belief is that the risk-returns are heavily skewed in favor of fixed income despite the well-touted mantra that bonds are in a bubble and that interest rates have to go up. Fixed income encompasses many different asset classes which can be used to build a diversified portfolio of lower risk returns.
Our strategy which can be followed on our new marketplace service is to combine select ETFs and open-end mutual funds with our proprietary closed-end fund strategy. Over the last five years, that strategy has returned in excess of 8.7% per year compared to the Barclay's US Agg's 3.25% return and the Barclay's Global Agg's 1.20% return. We have also combined this strategy with a risk overlay that attempts to reduce volatility and further lower correlations with the S&P 500 and bond market indices. That 'portfolio insurance' cost the typical portfolio roughly 230 bps of return but has greatly reduced the variability of the returns, increasing the Sharpe ratio considerably.
Our conclusion is that investors should expect muted returns over the next several years but that fixed income offers the better returns for the risk. This is contrary to most thinking that is expressed today by the Street and market pundits. If the S&P 500 were to fall by 30% or more, than we would probably shift that thinking towards equities. But as an investor and financial advisor standing here on June 13th, 2016, we cannot consciously allocate significant portfolio risk to equities until valuations come more in line with better future returns. The current central bank bubble driving the equity markets may last for a long time before a correction is experienced. However, the risk is clearly on that side of the portfolio equation and a better entry into equities is warranted.
*For more information on how we construct portfolios for risk-adverse investors and retirees looking for steady income streams without being exposed to the stock market, see our marketplace service.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.