Before we get started, let’s define what is meant by “capital market return assumptions”. This is a phrase the investment industry uses to frame the very important question, “What can investors expect to earn on their investments over the long-run?”. These assumptions are therefore very important to our clients when analyzing their long-term financial plan. Key inputs to any plan include current financial resources, expected annual savings, expected returns on financial assets, expected retirement date, expected income needs in retirement and life expectancy. Lots of “expected” items on that list, which requires us to make assumptions in a sea of uncertainty. It is also important to note that the longer the time horizon of a financial plan, the more impactful the assumption for expected returns becomes.
The components of expected future returns are fairly simple to identify and involve income plus capital gain (or loss). The capital gain/loss component is further broken down between growth and valuation. This framework is often called a “building blocks” framework to estimate future returns. Many people rely on historical returns to estimate future returns, since they are known data points. We, however, believe this methodology is like driving forward while looking in the rearview mirror. The mirror may be clean, but you are still asking for trouble. We would rather look through the windshield, even if it is all fogged up. At Ancora, we determine appropriate capital markets assumptions using a building blocks framework, outlined below.
Building Block #1: Income or Yield
For bonds, the expected returns are simpler to discern than for stocks, because, if held to maturity with no credit issues, they pay off at par with no capital gains or losses. The expected return then is merely the yield at which the bond is purchased. For example, with the 10-year Treasury Note currently yielding about 2.6%, we can safely assume that an investment in that security will generate a 2.6% annualized return over the next 10 years. A good assumption for long-term expected returns for high quality bonds (i.e. those with minimal credit risk), is the current yield to maturity.
For stocks, the process is more involved and not nearly as precise. However, the simple formula of income plus capital gains still holds. Starting with the income component we’ll use the S&P 500 as a proxy for stocks in general for the purpose of this example. The forward dividend yield on the S&P 500 is currently about 2.1%. Conservatively, we can start with that as our income component. There is, however, a good case to be made that adding in some level of stock buybacks would be appropriate as an additional component of income. This is where things can get tricky because stock buybacks are pro-cyclical. That means companies buy back more stock when times are good, and they have more cash, than when times are bad. According to Yardeni Research, since 1999 the stock buyback yield has been, on average, somewhat greater than the regular dividend yield. Yardeni also notes that dividends plus buybacks together account for almost all S&P 500 operating earnings since the 2008 financial crisis. This does not leave much in the way of retained earnings to fund growth. It is also important to note that both yield components went down significantly in the 2008 crisis, so this income is not as certain as the bond income. As we can see, with equities things can get a bit messy.
Building Block #2: Growth
On to the capital gains component, starting with growth. Over the long-run, stock prices should follow earnings growth. Earnings growth, in the long-run, is a function of nominal economic growth, which is broken down into real economic growth and inflation. Long-run economic growth is a function of labor force growth and productivity growth. This is the building blocks framework. According to JP Morgan in their U.S. 1Q 2019 Guide to the Markets publication, the U.S. labor force is expected to grow at 0.2% going forward and productivity growth in the last 10 years was just short of 1%. Long-term productivity growth has been higher than 1%. The final component to growth is inflation since, over the long term, earnings should keep up with inflation.
Building Block #3: Valuation
This building block could be termed the “speculative” component and is merely trying to capture a normalization of valuation measures. To estimate this component, we need to assume that there is a “normal” earnings multiple that the stock market will gravitate to over time. This is trickier than it sounds. For example, JP Morgan’s 1Q 2019 Guide to the Markets estimates that the average forward price/earnings multiple since 1994 has been 16.1x. As of 12/31/2018, it was 14.4x. This would imply a slight tailwind to returns as multiples move back to normal. Meanwhile, the so-called Shiller PE, a cyclically adjusted price/earnings ratio, was at 33.2x as of the most recently available data from September 2018 with the average since 1994 at 26.8x. This would imply a fairly stiff headwind to returns as multiples normalized.
To add further debate on the valuation component of estimated forward returns, profit margins are currently at all-time highs. According to JP Morgan, S&P 500 operating margins touched 12.1% in Q3 2018 while the average since 1992 is closer to 8%. If current margins were to normalize to that average, it would be a gale force headwind to profits and, in that scenario, stocks would have a difficult time generating attractive returns.
Using the building blocks framework, we believe that over the next decade and longer, bond market and stock market returns will be lower than they have been in the past for a few reasons.
- The starting yields for both the bond market and the stock market are lower than they have been historically.
- Earnings growth is likely to be lower than it has been historically due to lower real economic growth going forward.
- Valuation is likely to be either neutral or a mild headwind depending on multiple and margin normalization and the level of interest rates.
These assumptions are important for long-term planning purposes. As a result of this research, Ancora has incorporated fairly modest long-term return assumptions into financial plans for our clients. Please reach out to us with any questions you may have.