After seven years of extraordinary stock market returns (S&P averaged 14.9 percent annualized from 2009 - 2015) valuations are now full and the profit cycle appears tired. Assuming a 7 percent annualized total return over the entire bull market that began with the start of the cycle in 2009 (see explanation “A”) the next decade could see 3 percent annualized returns on average.
Put another way, over the next decade stock markets are likely to be more volatile and far less generous. Economies worldwide will struggle under high debt burdens and runaway deficits. Economic growth will remain sluggish and tax rates are likely to rise. Workforce demographics will become an economic headwind as worldwide populations age. Historically low interest rates will punish both pre-retirement savers and retirees dependent upon fixed incomes.
The end of the commodities super-cycle suggests commodity prices could remain under pressure for years, threatening additional deflation. Lower commodity prices are helping to burst emerging market credit bubbles across the globe including Brazil, Venezuela, South Africa and Nigeria. Domestic high yield credit defaults are on the rise and the U.S. credit cycle appears to be exhausting itself as well. Worldwide economic problems and the political unrest they often generate (i.e. the Arab spring) are likely to continue.
Understanding risks, especially deflationary risks, could become more challenging for advisory professionals. Arriving at a suitable asset allocation dedicated to each client’s specific objectives and retaining that mix over time may well determine the success or failure of the advisory process. With interest rates the lowest on record and government bonds no longer capable of supporting retiree lifestyles, risk assets (those with higher volatility like stocks or high-yield bonds) take on greater importance as dependence on them becomes more critical. Finally, rising volatility and difficult markets often lead to emotional decision-making and behavioral blunders.
Is Convention The Problem?
A major catalyst for the seven-year rally, the Fed’s controversial quantitative easing program, appears to be reaching its conclusion. With that, well-established return assumptions that rewarded over-sized equity allocations and allowed 4 percent plus retiree withdrawals may now prove overly optimistic. Lower baseline stock and bond returns (of 7 percent and 3 percent respectively) coupled with rising market volatility could challenge the sustainability of well-established and commonly followed investment advisory practices while further jeopardizing already vulnerable retirees’ lifestyles.