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.

One of the few ways that bonds might conceivably generate a positive return is if the Federal Reserve moves to a negative interest rate regime. Fed Chairman Jay Powell has voiced his opposition to this radical policy.

Arnott said it is possible since both President Trump and some Democrats favor it. “The temptation is bipartisan,” he argued. But if one looks at what’s happened to European bank stocks or the entire Japanese economy, the picture isn’t pretty.

The current political climate is also cause for concern. Former vice president Joe Biden has pledged to raise the corporate tax rate from 21% to 28%, a move that if enacted would translate into a reduction in many companies’ profits of almost 10%, depending on their deductions.

Both candidates also have big spending plans. “One candidate wants to run $2 trillion deficits as far as the eye can see,” Arnott said. “The other wants to run $3 trillion deficits forever. The problem is it’s impossible to tell which is which.”

Arnott is quick to concede that he is a value investor and the past decade has not been kind to him and his brethren in that space. In his opinion, the gap between growth and value is the widest it has ever been.

If one is looking to invest domestically, the beaten value sector is the place to be. Energy, retail and financial stocks all face secular challenges, but he believes these problems are reflected in their prices.

Mega-cap growth stocks continue to extend their dominance of the S&P 500. Research Affiliates conducted a study of Amazon’s long-term value and assumed it would grow at 20% a year for the next decade, and then grow at the rate of GDP.

Why would Amazon’s top line slow to the rate of GDP? At that point 10 years from now, it would be larger than all the retail businesses in the world. The researcher concluded that might justify a lofty P/E ratio of 70 today.

The only problem is Amazon’s current multiple stands at 130. “The [market] expectations during a bubble are for a continued bubble,” Arnott said. “Eventually you are betting against the median outcome.”