How to value the stock and bond markets and project future returns.
My future return assumptions for stocks, bonds, and gold for 2020 and beyond.
Investing ideas if return assumptions don't match up with your goals.
2019: The Year of the Turnaround
2019 turned out to be a great year for investors after the panic selling of late 2018. Pretty much every asset class went up this year, with the S&P 500 (SPY) up 31.2 percent including dividends, global equities (EFA) up 22.1 percent, aggregate bonds (AGG) up 8.5 percent, and gold (IAU) up 18 percent. My top pick for 2019, Micron (MU), went up 55.7 percent. To be fair, I also liked the stock before it sold off, but whether your return was great or good depended on exactly when you bought.
Data by YCharts
Extending the timeframe a little longer shows that while future historians may judge 2019 as a boom year, a lot of the returns that global equities experienced were simply losses recovered after the 2018 bear market (See 1994 and 1995 for a historical precedent).
Data by YCharts
The S&P 500 has returned a little more than 12 percent annually since the start of 2018. International stocks have basically been a wash over the past 2 years, up a little less than 2.5 percent annually. None of this information can directly make you any money, but understanding where to position for 2020 and beyond can.
2020: Equities are fairly valued, bonds are a little rich
At the start of 2019, equity markets were experiencing a significant amount of stress. The S&P 500 fell a little over 20 percent from the highs, and on Christmas Eve of last year, all anyone could talk about was how low the market could go. This created an opportunity, and as such, I projected roughly 12 percent 5-year annual returns for equities. Now, using the same model, I'm projecting an annual equity return of 9.4 percent (for the S&P 500). Note that returns are likely to be either lower or higher over the short run, but in the long run, the estimates will be more and more accurate.
My model is fairly simple. I use a modified Gordon Growth Model. Classic investment models often only account for dividends and growth in dividends, but in the 21st century, there are 3 ways companies can use cash. The first is dividends, the second is buybacks, and the third is to reinvest in internal projects or M&A. My model is neutral to how profits are distributed.
My model for equity returns:
Earnings yield (current year projected earnings/price) + earnings growth (I use nominal GDP growth for this) = total return
The S&P 500 is expected to earn $175 for 2020 and is priced at $3230. That equals an earnings yield of 5.4 percent. I'm projecting 2 percent annual inflation and 2 percent real GDP growth for the US, and for corporate profits to grow as quickly as GDP. That gets you a growth rate of 4 percent. Add them together and you get a 9.4 percent expected return for equities. There may be more value abroad for certain sectors of the market, as I calculated returns to be around 10.25 percent expected for Japanese equities. Other markets can have even better returns but require currency hedging to realize it.
It's fashionable for asset management companies to assume either multiple contraction or low earnings growth in their capital market assumptions. Big banks and asset management companies typically project returns around 6 to 8 percent for equities. Their math is rarely consistent with mine because they make money from gathering assets and fees as a percentage of AUM. Lower return assumptions mean clients contribute more money and managers can sandbag on expectations.
I view this as a conflict of interest because I'm able to do the math and make my own models. It's beyond the scope of this article, but I use a more complex methodology to determine what earnings multiples should be using supply and demand for capital based on cash rates. For example, the model predicted poor equity returns vs. cash in 2000 and the early 1980s.
Bond yields, however, are giving me pause. Equities historically can rise fairly sharply and still be fairly valued if the outlook for GDP and corporate profit growth change also. However, bonds have a different return model, so a rise in the price of bonds simply means you'll make less return later, much more so than for equities.
My model for bond returns is:
Bond yields (starting yields) + roll-down (capital gains) =total return
For the aggregate bond index represented by AGG and BND, starting yields are 2.7 percent. I calculate capital gains from roll-down at 50 basis points based on the current Treasury and corporate bond yield curves. This gets you a total return for bonds of 3.25 percent. I view bond returns as low right now and think aggregate bond returns will need to come up to around 4 percent if the economy stays strong, especially if the Fed is seen as cheerleading inflation above 2 percent. This corresponds to a 10-year Treasury yield of 2.5 percent or greater. 10-year Treasury yields are under 2 percent right now. I view 2 percent as the lower bound for sustainable Treasury yields since that's the rate of inflation targeted by the Fed (0 percent real yield). Bond king Jeffrey Gundlach has a lot to say about how low Treasuries yields are right now.
If you have a 60 percent stock/40 percent bond portfolio, this implies an expected annual return of 6.9 percent. If you are 70/30, your expected return is around 7.5 percent. If you're reading this and investing for retirement or another long-term goal, it's likely worth matching my return expectations against your future liabilities.
What to do if you can't achieve your goals in the current return environment
If you're expecting a shortfall based on your current allocation, you have a few options.
1. The most popular option is to increase your equity allocation. Pushing your portfolio to 80 percent stocks or greater can put your CAGR above 8 percent, and going 100 percent equities can get your CAGR over 9 percent. This is obviously pretty risky because you won't be able to retire if a bear market happens right before you expected to quit working. Finance theory confirms this is a risky approach compared to leverage. If you're going to take this approach, try to take it when you're young and not after a divorce or job loss in your 40s or 50s.
2. Another popular option that works to boost returns without necessarily boosting risk is to use statistical factors of risk and return to your advantage to get higher returns. Variants of this approach include investing in small caps, dividend growth investing, value investing, and tactical allocation strategies such as rebalancing and volatility targeting. Research shows you might be able to increase your returns by around 2 percent per year by doing this well.
3. Another option is to use risk parity style setups for at least a portion of your money. Finance theory shows this approach to be generally superior to concentrating risk in equity markets, as it's less popular and more diversified. For the same amount of risk as a 60/40 portfolio, risk parity portfolios when properly implemented have been shown to average 10 to 11 percent returns. However, this approach requires leveraging low volatility assets and a lot of people who try to implement these are going to screw up because they either don't know the theory, charge too high of fees, are buried in conflicts of interest, or are hamstrung by the Dodd-Frank compliance and regulatory climate, which only recognizes option 1 as the way to bridge a shortfall. Smart risk parity managers typically combine options 2 and 3 to earn superior returns.
Some relevant theory on risk parity portfolios I covered here and here previously. I've linked to dozens of research papers on various investing strategies from my articles here, always feel free to peruse!
4. The last and least likely option is to find the next Apple (AAPL), Microsoft (MSFT), or other millionaire-making stocks. This is the hardest to do, but it has been done before by at least tens of thousands of investors. This approach requires a strong stomach, as even highly successful stocks like Apple have seen drawdowns over 80 percent from peak to trough.
Capital market assumptions
Here are my full capital market assumptions going forward. Returns are likely to be higher or lower in the short run, but these are my expected long-run averages at current prices. I'm not going to hang a number on global stocks because I don't recommend a shotgun approach to investing in equities, given the fact that the S&P 500 is designed to take advantage of the momentum anomaly and the quality anomaly, whereas international indexes often aren't, and since international equity returns can be aided or hurt by hedging (or not hedging) currency. The Nikkei is fine to invest in without hedging, however, so I'm including it.
US large-cap stocks (IVV)
~9.5 percent annual returns
US small-cap stocks (IJR)
~11 percent annual returns
Japanese stocks (EWJ)
10.25 percent annual returns.
Total bond market (BND)
~3.25 percent annual returns
Long-term Treasuries (TLT)
~2.75 percent annual returns – these returns probably will come up to 3.5 percent if the economy stays strong, meaning TLT will drop 10 percent. However, the negative correlation (-0.32 R-squared, monthly) with stocks still makes it useful as a hedge.
1.5 percent return (no cuts, no rate hikes expected).
3 percent annual return (equal to the global rate of inflation)
Brent oil futures
10 percent annual return (subject to change if the term structure changes – this can go negative if market conditions change).
Equities are likely to continue to rise into the US presidential elections. Political prediction markets are showing Joe Biden as the most likely Democratic candidate. A moderate Democratic nominee is likely to reduce the amount of volatility going into elections, whereas a true socialist platform from the left is likely to stir more volatility.
Bond valuations are higher than equity valuations at the moment. Both credit spreads and real interest rates are low at the moment, meaning volatility is likely to be higher for bonds than is normal. I view the best approach at the moment as letting equity gains ride (if you want to cash in some gains for personal purposes then now is a fine time to do so, but I don't see a big need to de-risk to protect your portfolio). Technology stocks (QQQ), (VGT) have been on fire for the last 5 years, and again, I feel that the best course of action is to let gains ride.
If yields continue to rise, money taken off the table in bonds (TLT) can go back in, and if equity volatility rises significantly, then at that time taking profits can be sensible (hopefully at a higher price than now and after receiving a few quarters of dividends).
Right now, a balanced approach including strategic allocations to US and international stocks, a hedge position in Treasuries with the eye of adding money as yields rise, and a small allocation to gold and oil futures seem to be the best course of action. By reading this, I hope you get some ideas for your own portfolio!
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Disclosure: I am/we are long SPY, QQQ, MUB. 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.