Recently, I ran across a heated debate in an online discussion group about the returns used in various projections provided to clients. The debate started with one poster concerned about future returns. In particular, he worried that the Monte Carlo Simulation engine in his software was using the long-term historical returns for U.S. Treasuries as the proxy for bonds. He pointed out that with yields so low, illustrating a return near 5%, had to be unrealistic.
His solution was to change the default in his software to use the current yield on the 10-year U.S. Treasury as the mean. Other posters suggested that it was easier to just knock off a percent or two from the portfolio return parameters across the board.
Another poster quickly pointed out that the characterization of “unrealistic” had some embedded assumptions in it. Illustrating the viability of a retirement usually means a multi-decade time frame. Is it fair to assume that today’s rates will persist that long?
This triggered discussion about future equity return expectations. Valuations are above the historic average suggesting lower than average returns going forward. Will that actually happen? Valuations have been above average for years. Maybe something is different now. Even if that is not the case, will valuations remain high for the next few decades?
Then the debate shifted from how to alter the parameters to should planners alter the parameters from using historical data to using something else. It’s a worthy conversation.
One thing the historical record has going for it is it describes real life. The returns are not theoretical, they actually happened. The stock market crashed in 1929 and financial markets during the Great Depression were extremely volatile. Inflation was very high through the 70s. Corrections occurred every other year, on average. Almost every president has been in office when a “bear market” 20% decline in stock prices hit.
Yet the good ‘ole “4% rule” never failed. There should be some comfort in that for clients and their planners.
However, that record is far from a guarantee of future results. Just because something has always worked doesn’t mean it always will and just because something has never happened doesn’t mean it can’t. Plus there are aspects of the historic record that are less than comforting.
The 4% statistic is a U.S. phenomenon. Isolating other countries generally yield poorer results (Phau). There have been periods in which yields were low and there have been periods where equity valuations have been high but before the last few years, there had not been a time when yields were near historic lows and valuations near historic highs.
This nagging truth begs an exploration of what could happen.
Bond yields are highly correlated to future returns. In fact, if you select a specific maturity from a sound issuer, there is little doubt what the return will be. Between now and 2025, you don’t know what the bond will be worth on any future date but if you buy a five year Treasury today, in 5 years you’ll get exactly what you signed up for, roughly 1.63% as of this writing.
Equity returns are tougher. There aren’t any great predictors of future returns. The one valuation measure that has received the most attention for its predictive value is Shiller’s P/E 10 ratio. What is often lost in its mentions is the fact that while P/E 10 has more explanatory power than other valuation measures, the P/E 10 is not a great predictor.
A Vanguard study, “Forecasting stock returns: What signals matter, and what do they say now?” found that P/E ratios only explained about 40% of future returns from 1926-2011. P/E10 had an R-squared of .43 to subsequent 10-year returns, a slight improvement from using the one year P/E which had an R-squared of .38
If you are looking at valuation levels to move in or out of markets, you are likely to be disappointed. The best predictor of 1-year returns had an R-squared of a mere .12. As the study pointed out, “…stock returns are essentially unpredictable at short horizons… Quite frankly, this lack of predictability is not surprising given the poor track record of market-timing and related tactical asset allocation strategies.”
This also means that clients who read about high valuations and turn those statistics into an anxiety-riddled fear of a crash are likely working themselves up for no reason. A good financial planner may be able to bring some perspective to the table. The Vanguard study I cited was written in 2012. Valuations were high and yields were low then yet returns have been good for equity investors and more than adequate for reasonably constructed balanced portfolios.
The result of the last decade or so is another example corroborating the primary conclusion the authors of the Vanguard study make, “…expected stock returns are best stated in a probabilistic framework, not as a ‘point forecast,’” and should not be forecast over short horizons.