[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.]
Investment Outlook
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.
Bonds
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.
Stock Market
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 TIPS | 3% | 1% | None | None |
| US Corporate Bonds | 4% | 1.5-2% | Medium | Medium |
| TIAA Guaranteed | 4% | 1.5-2% | Low | 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.
Tomasz M. Beer, M.D
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
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.
Middle-Aged Investors
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.
Reduced Returns
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.
Inflation
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.
Example 1:
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.
Example 2:
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!]
Example 3:
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.
Older Investors
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!
Like contemplating a ddx of epic length on a medicine rotation…it could be anything, but we really have no idea.
Sounds like you can see why my EM mind just chose to stick with a static asset allocation and forget about it.
I like these data and conclusions since they happen to jive with my own view.
I have a ton of bonds and it is good to see you expect a smaller gap going forward between bond and stock returns. I may not be throwing away as much growth opportunity as so many tell me.
Also, as you alluded to, a lot of this comes down to psychology. Go back to your records in 2000 or 2008. Were you buying or selling or neither at low points in the market? Those who were selling at the bottom should likely invest in a lower percentage of equities. Those who haven’t lived through a 50% decline have absolutely no idea what they will do, even if they think they know what they will do.
One thing I have learned about the market is that you really cannot predict anything. There are so many points in this last extended bull run where people said surely this is the top of the market and better get out now and then subsequently lost gains as the market continues to rise.
I think creating an age/risk appropriate asset allocation is key and to stick to that by continuing to contribute to investments. Reassessing this asset allocation at various periods in your life is essential to appropriately adjust the % you have in each asset class.
Personally I have really started appreciating investing in real estate (tax advantages, less volatility, cash flow) but have chosen the less active forms available (private syndication). This allows me to build a good passive income stream and also gives me a little more risk tolerance on the market side.
People talk a lot about less volatility, but I don’t think that’s actually accurate. I think the asset just isn’t marked to market daily like the stock market so the volatility is hidden. Hidden volatility and less volatility are not the same thing. Reminds me of a lot of those private, broker-sold REITs that promised 8% returns and told investors their shares were worth $10 (and maybe more when we have a liquidity event eventually!) until they were worth $3.
When was this written? This line “But a reduced allocation to stocks, at least US stocks, may be prudent in 2018.” suggests it was written last year. I would say the message holds true today but if it was written in September vs November of last year it has a different feel to it. Either way, I agree with the message in the article but also agree with your comment on Wade Pfau in 2013. Many people have been bearish for the past 5-6 years. A good momentum article might be good about this time 😉
Not sure when it was written, but we often have delay for guest posts of up to 3-6 months between writing and publication. Can be longer for my posts. Not sure if the 2018 is an error or not. But either way, the market now is about where it was in September last year so whatever you feel would apply then would apply today.
This was written in later summer/early fall 2018. The view that I try to take is decade-long, and from that long perspective, little has changed over the last 6 months.
I recall people saying stuff like this back in 2011. Glad I didn’t do anything differently back then.
Lot of article, is it over 2000-3000 words ? Generic decent advise, and sound bites. Anything actionable (unless pushing towards bubble-territory priced rental Real estate or NNNs?)
Great summary of this guy’s thinking. A little suspicious of his mentioning annuities, but looking at my mom (now 91) going to the Fidelity brokerage to ask for advice has got to be worse…My take is now is a bad time to go all in on stocks if you are over the age of 50. If Kamala defeats Donald definitely a bad time. If Donald wins equities might just go a lot higher.
“Difficult to see. Always in motion is the future..”
– Yoda
I’m 37 and currently have an 80/20 mix. I do also factor invest in intl, small, and value using index funds.
I like to look at the Shiller PE ratio to see where the market is valued, and currently, it is way overvalued compared to historic averages. My question is, maybe higher PE ratios compared to the past is the new normal? Perhaps due to rise of 401Ks compared to pensions or perhaps the repeal of Glass Steagal or some other reasons.
I’m going to stay with my 80/20 mix going forward, but will go back to 100% stock if the Shiller PE falls drastically at some point in the coming years.
You might be waiting a long, long time if you want to change investments based on Shiller PE. It’s been 35 years since it was under 10 and other than a very brief period in 2008, 25 years since it was under 20.
https://www.multpl.com/shiller-pe
WCI, thats the question I was wondering, what is the new normal or average? It seems like since the 90s tech bubble, that the market has been higher on average than it ever was before for whatever reason.
I kinda like Nomi Prins’s theory that the effect of the Fed’s quantitative easing policy that started 10 years ago has basically been to keep inflating the stock market. Ditto for central banks in other countries.
Not sure how this theory is actionable though.
I think it is actionable in that you be willing to load up on stocks once the market crashes…which is who knows when. You could place more in bonds now and be willing to shift more to stocks if the market falls. You could also use the strategies in Life-Cycle Investing like buying options on SPY or use margins once the market falls. It would take some patience and guts and most people on this site probably wouldn’t agree with those options.
Yeah, I looked into SPY options briefly on Vanguard, but unfortunately I’m not bearish/crazy enough to bet that the market will tank in one specific period and the cost of holding these options for more than a few months seems to be prohibitive.
I say “not actionable” because if you buy the Prins theory, then either the Fed will be able to prop up the stock market for a few more decades or it won’t; I personally have no idea which. If it can, then we’d expect OP’s prediction of lackluster but positive market returns for the next few decades will be true, and I will skinny-FIRE in a few years with my 50/50 stocks/TIPS portfolio. If it can’t, then seems to me the next step is all that inflation the Fed’s pumped into equities has to seep into the general economy. In that case, bonds are hosed (+/- TIPS if you’re an optimist) and the value of all other dollar-denominated investments becomes pretty unpredictable, right?
The tricky part is the timing.
If that’s your plan, I’d define “drastically” and write it down.
It was to act if the Shiller PE ever reached 15…
We all like to say we’ll buy, buy, buy when the market tanks, but the proof is in the pudding. Most don’t, and those of us who have been there know why. Here’s a taste of how it felt in 2008:
https://www.bogleheads.org/forum/viewtopic.php?t=33849
I have several friends who seeked refuge in bonds when Trump got elected. They missed out on a great run. I gotta say, knowing yourself is the best thing to show you what the future will hold. Are you the person who can’t sleep at night when the market tanks or are you the person who seeks out awful days on the market to buy extra shares?
i have a friend who went all in to gold when Trump won!
As a Medical Oncologist, as is the author:
1) I wonder when in his training he received his crystal ball. When my patients ask me questions about the future, I joke with them that I missed the lecture when the crystal balls were being given out !
2) re. the following cut and paste; If 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.
If Wade Pfau got it wrong in 2013, I’m not sure anyone should really be trying to say what the future holds…….
Just a thought about CAPE that I originally wrote on Bogleheads:
“
Prior to 1975 to invest in the stock market one had to have some wealth and able to afford the very high transaction cost of buying and selling. In May, 1975 the trading fees were deregulated and gave the birth to discount brokerage houses. Schwab was one of the first to offer discount trading allowing mainstream investors to dabble in the stock market. Over the next 10 years more and more discount brokerage houses kept popping up increasing the volume of investors. With advent of the internet and the ability to track, buy, and sell stocks online, just about anyone was able to invest in the stock market. Since there were many more investors out there, demand for equities increased and as demand increased so has the price and the PE ratios. Maybe CAPE 30 is now the new average due to higher volume. Maybe with 2 billion people in India and China making more money and also investing in the market the CAPE may continue to rise even further reaching new highs over the next decade.
Just a thought.
“
All I know is that CAPE has not beeen a good predictor of returns in the last 25 years. Why should we think it will be any better in the next 25.
The trick is to keep an asset allocation that works irrespective of 1 or 2 indicators that may or may not mean anything.
Correlation is not causation. Maybe the explanation above is the reason. Maybe it isn’t.
It’s good to know all the theories. But it’s also important to know their weaknesses and just how much there is we don’t know.
My undergraduate training in science didn’t turn out to be all that useful for medical school, but it sure is useful at knowing when something is really proven.
For additional “weeds” and more pessimistic view, read John Hussman, PhD; https://www.hussmanfunds.com/comment/mc190408/
From his commentary:
“Understanding potential downside risk at a market extreme has a way of concentrating the mind. If I were to offer a guess, I’d suggest that regardless of whether the S&P 500 registers fresh near-term highs, investors should allow for the S&P 500 to be perhaps -30% lower by the end of 2019, on the way to losing an additional -50% of its remaining value over the rest of the down-cycle. That, after all, is how a market loses -65% of its paper value. That’s not so much a forecast as a base case. A -65% loss, unfortunately, would presently represent a run-of-the-mill cycle completion from current valuation extremes. As I observed at the 2000 peak, “If you understand valuations and market history, you know we’re not joking.”
I think I mentioned in the introduction to the piece that permabears exist. Hussman is one. They sound so smart and yet they are so wrong over and over again. Why is that? Morgan Housel explains why:
https://www.collaborativefund.com/blog/the-seduction-of-pessimism/
Valuations matter and can be helpful in planning.
Per Michael Kitces:
“The bottom line, though, is simply this: while the data does suggest that market valuation tools like Shiller CAPE are a poor predictor of short-term market performance, and may be very limited as a market timing tool to improve performance, the longer-term predictive value of Shiller CAPE and its CAEP inverse suggest that it is still relevant for planning decisions where the focal point truly is on long-term returns, from setting an appropriate safe withdrawal rate (or possibly even an optimal asset allocation glidepath) to evaluating the opportunity cost of funds for lifetime income strategies like delaying Social Security, purchasing an annuity, or considering a pension lump sum!”
“https://www.kitces.com/blog/shiller-cape-market-valuation-terrible-for-market-timing-but-valuable-for-long-term-retirement-planning/
It seems smart, but breaks down when you try to get specific. At what Shiller PE do you use a 3.5% SWR? At what PE do you use 4.5%? etc.
See Kitces and Pfau , “Increasing Retirement Withdrawal Rates Through Asset Allocation” (aaii.com/journal/article/increasing-retirement-withdrawal-rates-through-asset-allocation) for his answer.
Great, but carries the usual perils of data-mining. We already know what would have worked in the past.
An article in MarketWatch today about high valuations:
https://www.marketwatch.com/story/guggenheim-says-next-recession-will-be-less-severe-but-the-ensuing-stock-market-fall-will-be-brutal-2019-04-10?mod=mw_theo_homepage
I’m going to guess that Guggenheim’s crystal ball is just as cloudy as the rest of ours. Certainly that’s the way I would bet.
“When you won the game, stop playing”. Or reduce risks. Why? If you really win, and become good at it, why not keep playing. You have more resource to take more risks. If every successful companies stop operating ofter a little bit of success, we would not have many companies valued in billions. I bought Netflix stocks (for fun) about 6 yrs ago for 17k, now worth 500k. Just pure luck, I know. If in the next few months, I lose it all. I will say “It’s just a game.”
A good illustration of why tech stocks can be so dang alluring. Congratulations on your good fortune!
— TDD
Sounds like you’re now making a classic behavioral mistake. Money is fungible. That $500K you made on Netflix spends exactly the same as $500K saved from your job seeing patients and should be cared about to the same level. There is no “house money.”
I must admit that I had to look up “NNN” property to remind myself what this means.
For others in the same boat, a “NNN” property usually refers to a commercial property in which the “three net” expenses of property taxes, insurance, and maintenance are charged back to the tenant.
Anyway, the article, while dense, reads as a well written bear case to preferentially shift assets away from equities and into alternative assets that better chance of robust returns, such as real estate or business.
I’d agree with the commenters above that the trick is to figure out how to do this in a relatively passive manner, lest you just trade one job for another.
— TDD
A less theoretical question: can someone break down how exactly the IRR is calculated for those 3 examples? As in what numbers and what formula are utilized. Thanks.
The IRR was calculated using the relevant Excel function and taking into consideration cash outflows at the the time of the investment and inflows from income and the value realized from the ultimate sale of the investment after a 10 year hold (chosen arbitrarily). Nothing to fancy. Happy to send you the spreadsheet.
Hope this helps: https://www.whitecoatinvestor.com/how-to-calculate-your-return-the-excel-xirr-function/
Several readers see the article as being pessimistic. But I see it differently. Based on current valuations, I am not alone in expecting lower returns from US stocks over the next decade than historical averages. I am talking about the next decade, not the next month, year, or even several years. Could I be wrong about that? Of course. Like folks have pointed out, I have no crystal ball. But stock market returns are the result of dividends, of earnings growth (inflationary and real) which result in price appreciation and growth in dividends, and of valuation changes. That’s it. For the long term, these are the factors that drive stock returns. The valuation lever is less likely to be available to boost returns when the starting point is high. Could valuations go higher? Of course they could. But is that the most likely scenario?
I don’t see myself as particularly pessimistic. I expect positive returns from stocks. I am just not betting on the historically high returns. It’s not just because of valuations. It’s also because of interest rates. If the risk free rate of return is 2.5-3% in nominal terms and near 0 in real terms, to get a 10% rate of return from stocks, one would have to expect a larger than historical equity risk premium. Why would we expect that? And there should be little disagreement that bonds cannot deliver the kinds of returns that were available in the last 3 decades as interest rates declined from historic highs to historic lows.
None of my thoughts really speak strongly against maintaining a fixed portfolio allocation that is consistent with one’s financial goals and risk tolerance and capacity. If someone is a 60/40 investor, nothing about my outlook would make that a bad idea. I would just expect lower long term returns than such a portfolio delivered historically. And in that, I think I am far from alone.