[Editor's Note: The following guest post was submitted by an academic oncologist, Tomasz M. Beer, M.D. It gets way into the weeds of investing, discussing valuations and even including projections of potential future returns. Any time ideas like this are discussed, I think a few cautions should be stated up front:
First, nobody knows what is going to happen in the future. Current market valuations are not very accurate predictors of future returns, particularly short term future returns.
Second, even if you can predict future events, you must be able to predict the timing of such events well enough to capitalize on the event in order for the information to be actionable. Timing an exit AND a reentry well enough to overcome the costs is not an insignificant task and perhaps not even possible for the vast majority.
Third, if you really believe that future returns will be low, you want to consider both the likelihood and the consequences of you being right…or wrong.
Fourth, a pessimistic outlook on future asset returns should indeed, as Dr. Beer will point out, lead you to make different decisions, primarily spending less and working longer. Even paying back low interest rate debt for a guaranteed return becomes more attractive if you don't expect much from stocks and bonds. The risks and hassles of alternative asset classes such as real estate and small businesses may also be less onerous.
Fifth, beware of perma-bears. The idea that “valuations are high” and “future returns will be low” is neither new nor specific to 2019. Similar concerns were raised by none other than Wade Pfau, PhD, CFA in 2013 as I wrote about here. Over the last 5 years, the Vanguard Total Stock Market Fund has had an annualized return of 10.33% per year, including the very brief December bear market.
For all of these reasons, I prefer using a fixed asset allocation held through thick and thin, and then simply accepting what the market provides. Dr. Beer and I have no financial relationship. Enjoy the article.]
Today’s market conditions require careful consideration. Asset prices are high and return expectations are unusually low. While nobody can predict the movements of the markets in the short term, one can estimate long-term returns going forward, for example for the next decade based on known variables and historical data. Many investment houses offer their investment outlook. Vanguard’s is one I read annually.
Long term returns from bonds, provided that they are held to maturity, equal the coupon rate less default losses, and for US Treasury securities, just the coupon rate. Presently Treasuries are offering a yield of 3%, Investment grade corporate bonds 4%, and TIPS are offering close to a 1% real rate of return. Default rates on investment-grade corporate bonds historically approximate 0.1% per year and long-run historical returns of corporate bonds have exceeded those of Treasuries. However, corporate bonds prove to be a poor buffer against economic crisis, when Treasuries shine due to the “flight to safety” behavior of investors.
Long term stock returns may be estimated as the sum of dividends and the compounding effect of their reinvestment, earnings growth, and changes in the relationship between stock prices and corporate earnings (PE ratio). Stock repurchases are not a large factor market-wide as repurchases by some companies are counterbalanced by issuances by others and for any given company, the effect of a reduction in outstanding stock is reflected in that stock’s earning per share.
Currently, for the US market, the dividend yield is under 2%, the long run earnings growth rate has been 4 to 5% and is composed of approximately 2% real growth and 3% growth attributed to inflation. The price to earnings ratio of US stocks is very high by historical standards and while the future cannot be predicted, it appears more likely than not that reversion to the mean will subtract from stock returns over the coming decade.
10 Year Expectations
Using these data and considering a long run inflation expectation of 2 to 2.5%, one can propose the following 10-year market returns for various major asset classes, largely modeled after Vanguard’s analysis. The risk estimates are merely qualitative and reflect my views. My view of stocks’ poor ability to protect from inflation is based on their performance in the 1970s and refers to a 10-year time frame. In the very long term, earnings go up with inflation and stock prices must follow. But in the near term (a decade being the near term), stocks compete with rising interest rates on bonds and therefore inflation may accelerate PE compression which would hamper stocks’ ability to protect from inflation.
|Market return expectations for the decade following 2018|
|Nominal Expected Return||Real Expected Return||Risk of loss of principal||Risk from inflation|
|US Stocks||4% (3 – 5)||1.5-2%||High||Medium|
|International Stocks||6.5% (5.5-7.5)||4-4.5%||High||Medium|
|US Treasury Bonds||3%||0.5-1%||None||High|
|US Corporate Bonds||4%||1.5-2%||Medium||Medium|
What Do These Valuations Mean for Investors?
So, what are the implications of this situation for various investors? First, I would like to draw some distinction between market timing and age or situation-appropriate asset allocation. Some of my comments reflect the fact that young, middle-aged, and older investors have different levels of risk tolerance and different investment horizons. These distinct situations require different portfolios with different risk and return expectations. However, one could make a case that there are times in history when some adjustment based on market conditions is also warranted. Those times are times when risk is not being properly rewarded. The table above suggests that we may be facing such a situation now.
The expected total return from US stocks and from US corporate bonds is about the same. While bond prices can fall with rising interest rates, the total return of bonds held to maturity does not change and one might speculate that a significant rise in interest rates would put pressure not only on bond prices but similarly on stock prices. Recession, on the other hand, might increase corporate bond defaults but would also result in falling interest rates and therefore rising bond prices. Thus, these return expectations, at least in relation to one another, should withstand the expected range of interest rate fluctuations.
Young investors have it relatively easy. Poor returns early in someone’s investing career, provided regular contributions continue through thick and thin, and particularly if they increase over time, should have relatively little impact on ultimate outcomes. This is especially true for investors with a truly long investment horizon, for example, 40 years.
Such investors should regularly contribute towards a portfolio that is heavily weighted towards equities, both US and international. And they should hope for a market decline. History teaches that sooner or later, this hope will be realized and these investors will have the opportunity to add stocks at bargain prices. Such a price correction would also alter the relation between expected returns for asset classes and restore the equity risk premium back to a level where it belongs.
Investors in their 40’s and 50’s and also older investors who have not built their nest egg yet, are at greatest risk of being damaged by the current situation. These investors are in their peak earning, saving, and investing phase of life. They need the strong returns that markets have historically delivered to build adequate retirement savings.
Consider that a stock market return of 10% applied to a 30-year investment horizon would produce a bit more than 4 doublings of an initial investment. Every $10,000 invested at 10% for 30 years produces more than $160,000. This sort of return is what makes it possible for Americans to retire securely. When that annual return is reduced to 5%, we can expect 2 doublings, yielding only $40,000. Thus, the difference between 10% and 5% is staggering when applied for an extended period of time.
The picture gets even worse when one subtracts a 2% rate of inflation. The real rate of return then drops to 8% and 3% respectively. And a 3% real rate of return means that the value of an investment held for 30 years barely more than doubles in real terms. Meanwhile, the real value of an investment exposed to a real rate of return at 8% goes up more than 8-fold.
Things may not be quite so dismal because present conditions may not persist for the entire remaining investment horizon of these investors. Estimates of expected returns are constructed around a 10-year horizon. Forecasting beyond that is an impossible task.
Changing Market Conditions
At some point during the investment life cycle of these individuals, market conditions may change (likely through a correction in stock prices). Investors who are diversified can take advantage of such shifting conditions through rebalancing and enjoy the subsequently improved returns, although they will sustain some losses through such events. Indeed, the sooner such a correction comes, the better for these investors.
Portfolio Diversification and Allocation
So, what should folks in this situation do? First, stay diversified, and consider adopting a portfolio that would traditionally be considered more conservative than would be typically recommended. A higher allocation to bonds would enable these investors to rebalance to stocks when opportunities arise while limiting damage from a correction. It would also capture much of the expected return with less volatility.
This is, of course, a form of market timing, but one that is founded in fundamental analysis of market conditions. Put another way, when the expected return of stocks, which represent second-position claims on corporate earnings approximate those of corporate bonds which are entitled to corporate assets ahead of equity owners, the argument for stock ownership gets weaker. Abandoning stocks altogether would be imprudent given their diversifying role and their potential for growth, and the fact that no one can truly anticipate the future and it may look different than our current expectations. But a reduced allocation to stocks, at least US stocks, may be prudent in 2018.
Saving or Working Longer
Saving more, working longer, and planning for part-time work during retirement is the advice offered by many respected financial thinkers. For many Americans, saving more may not be realistic. More money means a reduction in the current standard of living. If market returns are low for a very long time, the savings commitment would have to be increased substantially, likely beyond the capacity of most investors. Saving more is a good idea, but may not be sufficient nor feasible.
Working longer or working during retirement is everyone’s plan B but should not be the plan A. Some people are passionate about work and foresee working well into retirement age. They may change their mind when they are older. Or they may continue to feel that way. Having the option to extend one’s working career is a great thing. But having no choice is not. For many Americans working longer may not be a realistic option. Deteriorating physical health, cognitive health, or just aging can make it hard to work late in life. Jobs may not be available. And it is not possible to know in advance if working longer will be either feasible or desirable. Working longer may prove necessary, but that needs to be the back-up, not the primary plan.
Seek Higher Returns With Alternative Investments
The alternative is to seek investments with higher returns. This is risky, hard, and requires work. But it may be the only way. I am not suggesting investing in obscure market segments that can collapse, cryptocurrencies, or other investment that are associated with excessive risk.
Within the securities markets, much is written about “factor investing” such as tilting the portfolio in favor of smaller stocks or value stocks or other factors. These factors have outperformed the overall stock market over extended periods of time and have done so with greater volatility. Because they appear riskier, many authors believe that over the long term they may continue to outperform, that the outperformance represents the risk premium, compensation for greater volatility. Critics suggest that with growing awareness of the historical advantage of these market segments, the advantage may not be repeated.
It is impossible to know what the future will bring. My view is that such portfolio tilts may bring a bit of extra return (but not enough to raise the expected return all the way up to the 10% or so that the overall market has historically provided), but if they do, it will be accompanied by greater risk. At a time when risks in the stock market are already elevated, investors must consider the possibility of greater losses or tilting their portfolio to small and value stocks.
While many assets are priced high today, this is particularly true of marketable securities. Marketable securities command premium pricing in part because they offer immediate liquidity. Immediate liquidity is not an important attribute for investors with a 20 or 30-year time horizon. The ability to liquidate assets when the capital is needed is, of course, important, but with planning, investors can manage through complex liquidation transactions.
Investors may be able to realize greater gains by giving up liquidity – and investing sweat equity. Perhaps that is a second home that is rented out long term – or through a short-term rentals platform. Or perhaps a duplex or a small apartment building. Commercial real estate can be found at CAP rates of 5 to 6. With careful leverage, tax advantages, and reinvestment in the property through principal repayment, higher rates of return are possible. Perhaps there are some other passive income investments that this investor is familiar with and capable of managing. Perhaps the investor is in position to purchase a profitable small business and operate it.
Such investments are riskier and require knowledge, skill and some luck. William Bernstein says that rental real estate is not an investment, it’s a job. And he is not wrong (although at a certain scale, one can pay others to manage it). Real estate can become overheated, recessions create significant stress for landlords. Buildings can sit empty between tenants. It is not an easy road. But there are ways to start slow, learn, and build.
A single-family home in a stable market that can generate sufficient rent after expenses to cover the debt service may be a place to start for many people. Low leverage ensures that one can withstand reduced rents in a recession. Adequate cash reserves to weather the unexpected should be a part of such a strategy. The below example summarizes returns on a single-family home investment based on stated assumptions.
A single-family home purchased with 25% down using a 30-year mortgage at 5% that is capable of generating rental income sufficient to cover all expenses.
The purchase price would need to include all necessary improvements to rent the home out. And rental income would need to cover not just the mortgage and taxes, but truly all expenses, such as insurance, repairs, vacancy, improvements, management fees, etc. If such a house appreciates at 2.5% per year, basically the rate of inflation, the combination of appreciation, loan repayment of principal, and leverage would produce an internal rate of return (IRR) of 11% per year over 10 years, this without any cash income from the property.
There are many parts of the country where it is not possible to buy a house whose price is sufficiently low and rental income sufficiently high to achieve this, but there are places where it is possible. And the assumptions are reasonable and fairly conservative and include a margin of safety.
For example, if an unexpected expense equal to 10% of the purchase price is needed mid-way through the investment period, the IRR is reduced to a respectable 8%. If the property does not appreciate at all, the debt repayment alone generates an IRR of 5%.
Owning a rental house adds work and stress and is not a guaranteed investment. But purchased at a reasonable price and managed well, it is an investment that has a realistic potential of generating a return near 10% per year. The same math applies to duplexes, small apartment buildings, etc.
A NNN single tenant property with a long term lease with a highly reputable and financially strong tenant purchased at a CAP rate of 6 with 30% down using a 20-year mortgage at 5.5%.
If such a property appreciates at 2.5% per year due to scheduled rent increases, the combination of appreciation, loan repayment of principal, and rental income would generate an internal rate of return (IRR) of 13% per year over 10 years. Even if purchased without any leverage – with cash – such a property would generate a 10% IRR over a 10-year holding period. Higher leverage and better financing terms would yield higher rates of return.
Such properties are leased to fast food restaurants, retailers, and other similar tenants. You likely drive by many such properties every day. They may prove fairly easy to operate with very long-term leases and all operating responsibilities resting with the tenants.
The principal risks involve the fate of the tenant or the retail location. Some of these properties are built to suit a particular tenant and if that tenant falters, the owner may struggle to re-lease the property or may need to modify it extensively. Long term changes in the market are hard to anticipate and some tenants or some locations that are strong now may not thrive for the next 20, 30, and 40 years. A prolonged vacancy in a single tenant property could be quite impactful. Properties that are in strong location and would be in demand by other tenants are less susceptible to such risks.
NNN properties offer a bit higher rates of return than single-family homes and potentially involve less work. But they do come with greater long-term risk. If your tenant goes out of business, the property may lose quite a bit if its value if it cannot be re-leased at similar rates.
Not everyone is willing to undertake such ventures. And there may be other similar opportunities for some investors. But with return expectations in the securities markets unusually low, less liquid investments with higher potential returns deserve consideration. One can start slow and learn, for example by subletting one’s basement room to try one’s hand at being a landlord. One can also pursue such opportunities with a partner. Partnerships can be challenging at times but good partnerships bring together trusted people with complementary skills and abilities and double the wisdom and judgment and half the work. Think of Walt and Roy Disney or Larry Page and Sergei Brin.
I am not suggesting that middle-aged investors swing for the fences or take risks they cannot manage. Hard work is likely to be required to find such opportunities and execute on them. There is, of course, incremental risk in engaging in such investments. This risk should be considered in the context of an overall portfolio. Perhaps a more conservative allocation between stocks and bonds in one’s securities portfolio can buffer the risk of an illiquid investment, just as it would a higher allocation to stocks.
For those with much energy and expertise, buying an established, profitable small business could be another option. Private equity firms do this all the time. Small investors can too. Running a business can be hard work and small businesses fail often. This is a high-risk endeavor. But I am not talking here about starting a business from scratch, the higher risk venture. I am referring to buying an established, operating business that has a track record, a customer base, and strong management. Not for the faint of heart, such investments can yield substantially higher returns when things turn out well. Consider that small businesses trade at 5 to 7 times earnings, far less than common stocks. [Editor's Note: Online businesses can trade at even lower valuations–2-3 times earnings–but there's a reason for that!]
A successful, profitable small business purchased at 6 times earnings with 50% down using a 10-year loan at 7%.
If such a business can grow earning approximately 5% per year (the same assumption as the overall stock market), the combination of appreciation, loan repayment of principal, and business income would generate an internal rate of return (IRR) of 37% per year over 10 years. Even if purchased without any leverage – with cash – such an asset would generate a 27% IRR over a 10-year holding period.
Small businesses are hard work and they can and do fail. When earnings shrink, the value of small business plummets. A business without profit is worth little more than its assets or less if it has liabilities like lease obligations or severance packages. Small businesses are hard to operate on a small scale. Large investors can absorb the costs of management, accounting, marketing, etc., and spread these out over many locations. Owning a small business is no easy task. On the other hand, experienced business operators can improve business performance and rapidly generate outsized returns. Fortunes are made by highly skilled and well capitalized operators who acquire under-performing businesses and apply their skills and capabilities to improve performance.
This is not an exhaustive list of ideas, but instead some examples of the sort of endeavors that enterprising investors can consider for a portion of their portfolio.
For those nearing retirement or in retirement already who are fortunate enough to have accumulated sufficient assets, an extended period of poor returns or losses early in retirement is the greatest threat to their plans. We do not know the future, but current market conditions suggest a high probability of lower than historical returns and relatively poor compensation for running stock market risk. Perhaps the adage that, “when you have won the game, stop playing” is worth remembering.
If the assets are truly sufficient to fund retirement, risk needs to be reduced. William Bernstein emphasizes asset-liability matching as a strategy and reminds his readers of rare but potentially catastrophic risks as well as the ordinary market volatility. Using safe assets to fund specific financial needs at specific times can risk-proof one’s retirement. This necessarily means accepting lower returns.
The safest assets are US Treasury securities, including inflation-linked bonds that provide a modest but guaranteed real return. A ladder of Treasuries or TIPS can be constructed to cover at least some minimum level of retirement financial needs, for example. If assets remain, these can be invested in riskier assets.
Alternatively, purchasing an immediate annuity from a strong insurance provider can result in guaranteed income and supplement other guaranteed income streams like Social Security. The risks associated with the failure of the insurance company that is selling annuities, while low, should also be considered, particularly in light of the long time horizon ahead for many retirees.
At the very least, a more conservative portfolio allocation when the expected returns from US stocks is not substantially different from the expected return from investment grade US corporate bonds is worthy of consideration. A focus on capital preservation is appropriate for those retiring with current market conditions.
What do you think? Do current valuations impact you how you invest? What about how you spend, how long you work, or your debt vs investing dilemmas? Comment below!