Note: This post was updated on 5/16/17 with new information
For planning purposes, I have always found it useful to look at 10-Year U.S. stock and bond return projections. Now for someone who is committed to a buy and hold approach AND has a 30+ year time horizon, valuations probably do not matter all that much. Even for those individuals, I still find this to be a useful, once a year exercise.
For those that have a shorter time-frame to a financial goal, or are in the withdrawal stage of life, this can be an almost mandatory yearly exercise.
As anyone will tell you, there is no perfect way to predict future returns, over short or long periods. There are ways to help point us in the right direction though. There are some indicators that have proven to be useful in giving us long-term expected return probabilities.
The most famous long-term value indicator would be Robert Schiller’s Cyclically Adjusted Price-to-Earnings Ratio or CAPE. This ratio has spawned a massive debate in the investment world ever since it’s publication back in 1988 (Note: Original credit should be given to Benjamin Graham and David Dodd for making the argument that earnings should be smoothed out over a 5 to 10 year period in their book Security Analysis back in 1934). The topic of CAPE and its usefulness has been covered extensively by many great investors over the years. I have omitted the graphs and tables from this conversion because for our purposes, it is too volatile of a tool.
When the CAPE ratio is at extremes and signals that markets are very cheap or very expensive, it works great. When it signals that markets are just a little expensive or a little cheap, results are all over the map. If we want to use our tool for financial planning purposes, this becomes a problem. As a quick example, there were certain times where the actual 10-year returns of the S&P 500 were more than 7%/yr different compared to what the CAPE model predicted. That will not fly if using this for savings/withdrawal decisions. That is why we did not include the data below.
Another famous long-term value indicator is Warren Buffet’s Market-Cap to GNP Ratio. This was one of the indicators that help warn Mr. Buffett of the famous 1990s tech bubble. Similar to this ratio, John Hussman has introduced the Market-Cap to GVA (Gross Value Added) Ratio. “Over-simplistically, GVA is the grand total of all revenues, from final sales and (net) subsidies, which are incomes into businesses. Those incomes are then used to cover expenses (wages & salaries, dividends), savings (profits, depreciation), and (indirect) taxes.”
We then have a much less famous, but very successful long-term value indicator which is Household Equity Allocations. This indicator was written about by anonymous blogger Jesse Livermore over at Philosophical Economics.
Lastly, I wanted to take a look and see what happens if we combined the Household Equity and the Market-Cap to GVA indicators into a super predictor.
So, how well have these two indicators done over the last 70 years? Let’s take a look.
Market-Cap to GVA (Gross Value Added)
Hussmans’s preferred choice has done very well historically. There were only two 10-Year periods that were outside of the +/- 5% band (5.04% and 5.05%). The average range around the prediction was +/- 1.81%. 80% of the time, the actual 10-Year returns were within a +/- 3% range. These are all solid stats.
Household Equity Allocations
From testing, this was the best stand-alone performer. The Household Equity Allocations indicator had the smallest number of large surprises (0!) and it also had the smallest average range between actual and expected returns (1.71%). The maximum miss was less than 5%, which is a great indication of its usefulness for planning purposes. Lastly, when we look at the scatter plot, we can see just how low the volatility of predicted and actual returns are via the R-Square score at 0.8961.
Whenever you can combine indicators in finance, it almost always improves their ability to provide information. In this case, there was a clear benefit in doing so. I gave the Household Equity Allocations indicator a 60% weighting since it was the best standalone performer, and then gave the Market-Cap to GVA indicator a 40% weighting. The results were impressive.
First of all, just notice the fit, it’s beautiful. Okay, onto more important facts now. There were 0 big surprises! Fantastic. The average range between actual and expected returns is by far the smallest (1.24%), another big win for planning purposes. It also had the smallest maximum miss (3.51% versus next smallest at 4.97%). Additionally, when combining the two indicators, you get the largest number of readings to fall between +/- 3% of the expected return (54!). Lastly, the scatter plot gives us the highest R-Squared score of any indicator at 0.9193. All very solid improvements over any of the stand alone indicators.
This is the type of tool that could be very useful in making decisions around shorter-term goals like savings rate in the last decade before retirement, college planning for kids/grand-kids, withdrawal strategies in retirement, etc.
For what most people are here for…
What is the combined indicator saying today? If you look above you will notice it gives a base case expected return of 3%. The pessimist would use 0ish% and the optimist would use 6ish%.
To get a quick picture of all of the indicators, here are some of the stats side-by-side:
Now, those U.S stock expectations are not exactly awful (i.e. Negative), but they are not great. This not a surprise though. Most knowledgeable investors from Bogle to Asness to Buffett have all been calling for below-average returns over the next decade. There is no hiding in the US stock market it seems and the US bond market does not look much better…
For those scoring at home, that gives a US 60/40 portfolio a base case predicted annual return of 2.8% over the next decade…
For individuals who use historic returns and are making planning assumptions based on a US 60/40 returning 7ish% per year, there could be a bad day ahead.
As I have mentioned before, for those who have financial goals they plan on reaching in the next decade or two, be careful about your assumptions. The fact is that in order to reach those goals, you may have to take on more stock risk, save more, delay your goals, or lower the expectations of those goals.
Another tip would be to make sure you are diversified globally. Valuations outside of the US are in a much more favorable spot. Now is NOT the time to abandon an international allocation.