After almost 11 years of the S&P 500 returning nearly 16% annually, expectations of pedestrian returns for the coming year are accepted by many advisors. Research Affiliates founder Rob Arnott believes even those expectations are optimistic.

In his view, a traditional 60-40 portfolio is likely to deliver somewhere between zero and 1% over the next decade, a period when all baby boomers will have reached normal retirement age. What is most striking about his scenario is that, if it materializes, equities would still be expensive by historical yardsticks in 2030.

Mean reversion, or simple price-to-earnings multiple compression, lies at the center of Arnott’s thesis. To revert to historical norms, the multiple on the S&P 500 should decline by 6% a year over the next decade.

But since the mid-1990s, markets have consistently priced stocks at levels significantly higher than they did for most of the 20th Century. Arnott factors that into his thesis.

Consequently, his scenario calls for multiples to decline at a more modest rate of 3% annually. That takes the Shiller CAPE ratio, a cyclically adjusted, 10-year average of the S&P 500, from its current level of 29 to about 23. That isn’t cheap by almost any standard.

Among his underlying assumptions that produce this conclusion are a 2% dividend yield, real earnings growth of 1.5% and real returns of 0.5% or thereabouts. In Arnott’s view, this is an optimistic projection.

“It assumes earnings and dividends hold, and that there are no long-term growth headwinds and a normal number of bankruptcies,” he explained.

Few people believe that bankruptcies will remain normal in the pandemic’s wake. “I can’t believe people are still calling this a recession,” Arnott said, adding that if ever there was a depression, this is it.

He has a point. In the two years after the Great Recession began in December 2007, America lost nine million jobs. Contrast that to the 40 million unemployment claims filed in the four months since March.

If the outlook for equities isn't too rosy, get a load of bonds. What’s happened to the economy and, concomitantly, to the bond market, is the reason why Arnott anticipates bonds will have a worse decade than stocks. Ten-year returns for bonds should come in somewhere around -0.5%, he said. Put that together with a 0.5% return for a stocks and a 60-40 just manages to eke out a positive real return.

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