Modern portfolio theory is the framework around which many advisors build portfolios.
But MPT came with a warning label: The model is only as good as the assumptions you make about estimated returns, said well-known market researcher Ed Easterling, founder of Crestmont Research.
And the assumptions advisors are making today about expected returns are, in many cases, way off base, said Easterling, who describes himself as a “market climatologist.”
That’s because advisors are not taking into account the fact that the market is seriously overheated because of high valuations.
Normalized P/E ratios on U.S. stocks (of near 30) are higher than they’ve ever been except for the late 1990s, Easterling said in an interview Tuesday.
That means advisors can expect, at best, a 5 to 6 percent annual return over the next decade. And that best-case scenario will occur only if inflation stays low, which supports higher multiples. If inflation moves up to around 3.5 percent, that could cause multiples to shrink and returns to drop to 1 percent. If slower growth causes multiples to contract even further, average annual total returns from U.S. stocks over the next decade could run into negative territory, Easterling said.
“I have no ability to predict what the market will do next year, but I’m pretty confident over 10 years,” Easterling said.
(Similarly, money manager Research Affiliates is estimating a mere 0.6% average annual return for the S&P 500 index over 10 years: Two percent from dividends, 1.3 percent from earnings growth, but a loss of about 2.6% per year from a contraction in the current 10-year Shiller P/E of 29.)
While it is likely returns will be below average for the next five to 10 years, there are things advisors can do to mitigate the damage, Easterling said. The foremost thing is to minimize losses.
“The tortoise might have the advantage over the hare,” he told attendees last week at the Investment Management Consultants Association’s annual meeting in San Diego. “If you reduce the variability of return, you get a greater compounded return.”