Lessons From The 'Naughties'
February 23, 2010
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Last month, we examined the Lost Decade and learned that much of the pain of the past 10 years was caused by an overreliance on the equity risk premium and the corrosive effect of capitalization weighting our equity holdings. Simply bypassing these two practices would have delivered respectable 7–8% annual returns. But past is not prologue. History is littered with the folly of building yesterday’s army to fight tomorrow’s war.
In this issue we apply the lessons of the recent Lost Decade to current market conditions. From an asset allocation perspective, the outlook for the ubiquitous 60/40 blend remains bleak. Unfortunately, moving away from this standard mix to a broader toolkit of risk exposures is likely to be less profitable than it was in the past decade as yields from diversifiers like REITs, TIPS, and emerging market bonds are well below the levels of 10 years ago. The key to better returns will be to respond tactically to the shifting spectrum of opportunity, especially expanding and contracting one’s overall risk budget. This approach, combined with “better beta” choices like the Fundamental Index® concept (which currently sports an unusually deep discount, relative to capitalization weighting), should help us to achieve our targeted returns in what—we shudder to suggest—is likely to be another tough slog for investors.
Busting Out The Crystal Ball
Naive mean reversion would indicate that 10 lean years for the 60/40 blend (60% S&P 500/40% BarCap Aggregate) ought to be followed by a decade of relatively strong results, especially when the recent lean years delivered the first ever decade of negative real returns! Of course, this assertion can only be verified with a perfectly tuned crystal ball.
While we take great pride in our asset class forecasting, we unfortunately don’t have such a device buried in our research department. But we can reasonably project likely future asset class returns by starting with their key Building Blocks. The long-term return on any investment can be broken down into income, growth in income, and changes in valuation levels. Table 1 illustrates these components, save for changes in valuations levels (more on that later), for the S&P 500 and BarCap Aggregate Bond Index as of December 31, 1999, and December 31, 2009.
Let’s start with equities because we spent most of last month’s issue of Fundamentals on their Lost Decade. The dividend yield on the S&P 500 was 2.1% as of December 31, 2009.True, that’s almost double the rate at the end of the 1990s, but it’s still puny relative to a long-term average of 4.5% since 1900. If we add a historic growth rate to those dividends, we arrive at an annualized real long-term expected return of 3.3% for stocks, assuming no change in valuations. Clearly, 10 years of poor returns hasn’t materially impacted expected future returns. As some wags have suggested, the Tech bubble discounted not only future growth but also growth in the hereafter.
On the bond side, the current yield to maturity is an excellent predictor of future long-term returns. Accordingly, bonds helped the 60/40 portfolio in the Lost Decade as they started with a yield of over 7%. Today the yield is about half as large. Backing out today’s breakeven rate, we see a core bond portfolio can be reasonably expected to achieve only an annualized 1.8% real return.
So, a reasonable expectation for a standard 60% stock and 40% bond mix over the next 10 years is a real return of 2–3% per year, again assuming no change in valuations. Yikes! The Lost Decade has most assuredly not paved the way for easy times in the years ahead. We’re still in a low return environment. This is a commonplace observation but most observers refer to low returns relative to the 1980s and 1990s, not the last decade.