Category Archives: Investing Money

Vanguard’s Chairman Sees Muted Decade for Stocks After Long Rally

My Comments: Little is said these days about those who are investing for the future and are still working vs those investing for the future who are no longer working. Think of it as being defined as the accumulation phase of your life vs the distribution phase of your life.

Different rules apply. Vanguard Funds founder John Bogle famously suggested that the bond part of your portfolio, presumably the ‘safe’ part, should be equal in percentage terms to your age. If you were 70, for example, 70% of your portfolio should be in bonds.

Demographics, interest rates, and the profusion of new financial products has largely put Bogle’s dictum to bed. But it does illustrate the continued confusion caused by those who fail to recognize the difference between someone in their 50’s working hard to accumulate a sufficient pile of money for retirement from someone in their 70’s trying to make sure they don’t run out of money before they run out of life.

We are currently conditioned to positive returns from the markets, except for 2015, that started as we emerged from the Great Recession of 2008-2009. Those of you in the distribution phase of your life need to heed the warning expressed here.

By Nico Grant | January 17, 2018

F. William McNabb, Vanguard Group’s chairman, cautioned investors to consider reducing their stock exposure before the nearly 9-year-old rally ends.

“We would expect the next decade to actually be very modest on the equities side in the U.S., a little less so in Europe and a little less so in Asia,” McNabb said in a Bloomberg Television interview that aired Thursday. “But it’s still overall lower than long-term historical averages.”

Stock markets reached a fever pitch in 2017 as the S&P 500 Index hit record highs and the rally has continued this year. The advance, buoyed by low interest rates around the world, economic growth and the U.S. tax overhaul, has sparked concerns that valuations have gotten stretched, spurring some investors to brace for a decline.

McNabb, whose firm oversees about $5 trillion, said long-term investors may benefit by holding balanced portfolios with bonds as well as stocks.

“No one can predict what’s going to happen in the next 12 months,” he said. “Having just said that, I’m sure the equity market will continue to skyrocket for the next few months.”

McNabb, who ceded the role of chief executive officer of the Valley Forge, Pennsylvania-based firm to Tim Buckley this month, spoke to Bloomberg in Beijing, where Vanguard is eager to take advantage of China’s opening to foreign financial-services companies. The country’s government said it plans to remove ownership limits on banks and allow overseas firms to take majority stakes in local ventures.

“With some of the changes, it looks like there may be a path to doing retail mutual funds, depending on how things get interpreted,” McNabb said.

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How your 401(k) can survive and thrive in the next bear market

My Comments: Some of you reading this have money in 401(k)s and 403(b)s and cannot simply remove it and place it somewhere safer. Which means you’re completely exposed to the vagaries of the markets and you can only hope for the best.

I learned long ago that HOPE is not an effective investment strategy. So these words from Adam Shell may make your life a little easier. If you want more information, you know how to reach me.

Adam Shell, March 9, 2018

The nine-year stretch of rising stock prices won’t last forever. So now’s a good time for investors to bear-proof their 401(k)s before the next financial storm.

The current bull market, now the second-longest ever and celebrating its 9th birthday on Friday, is most likely in its final stages, Wall Street pros say. That means a bear market will occur at some point, and the stock market will tumble at least 20% from its peak.

What could cause it and when? No one can know for sure. A recession perhaps, or a surge in interest rates and inflation? An unexpected event or investors getting too giddy about stocks and driving prices up to unsustainable levels? All could be the triggers of a big drop in stocks.

Remember, if you have any money invested in stocks, you won’t be able to avoid all the pain that a bear inflicts on your 401(k). While a drop of 20% from a prior peak is the classic definition of a bear market, most drops are more sizable. The average decline for the Standard & Poor’s 500 stock index in the 13 bears since 1929 is 39.9%, S&P Dow Jones Indices says. A swoon of that size would shrink a $100,000 investment in an index tracking the broad market to roughly $60,000.

Prepare ahead of time

“The best way to survive a bear market is to be financially prepared before one happens,” says Jamie Cox, managing partner for Harris Financial Group.

That means not having 100% of your money invested in stocks near a market top. It also means maintaining low levels of debt and having some emergency savings to avoid having to sell stocks in a down market to raise cash, he says.

From a portfolio standpoint, make sure your investment mix isn’t too risky. Are you loaded up on high-fliers that have greater odds of suffering steep drops if the market tanks? Make sure you own some “defensive” stocks, such as utilities, consumer companies that sell everyday staples like soap and cereal, or health care names, which tend to hold up better when markets fall overall.

“Investors should take the time to control the parts of their portfolios they can control,” Cox advises.

If, for example, your portfolio was designed to have 60% in stocks, and that percentage has ballooned to 80% due to the long period of rising stock prices, consider “rebalancing” your portfolio now. Sell some stock to get back to your initial 60% target.

Play defense

The time to be aggressive in the market is when stocks are up, and you can make tactical moves likes cashing out stocks, says Woody Dorsey, a behavioral finance expert and president of Market Semiotics, a Castleton, Vt.-based investment research firm. It makes more sense, he adds, to be defensive when the market is entering or in a period of falling prices.

“Does a bear market mean an investor needs to freak out? No. But it does mean you should be more careful,” Dorsey says. “If the market is going to be difficult for one or two years, just get more defensive. Keep in simple.”

One simple strategy to employ is to get “less exposed to the market and raise cash,” Dorsey says. “Most people are not used to that message, but it’s a good message.” While a normal portfolio might consist of 60% stocks and 40% bonds, a bear market portfolio, he says, might be 30% cash, 30% U.S. stocks and the rest in foreign investments and bonds.

Main Street investors could also consider defensive strategies employed by professional money managers, he says. They can buy things that hold up better in tough times, such as gold. Or add to “alternative” investments that rise when stocks fall, such as exchange-traded funds that profit when market volatility is on the rise or funds that can short the market, or profit from falling prices.

Identify severity of bear

The next bear isn’t likely to be as severe as the epic one following the Great Recession or the dive in early 2000 after the dot-com bubble burst, says Liz Ann Sonders, chief investment strategist at Charles Schwab. Both of those bears saw market drops of about 50% or more.

“The next bear will be a more traditional one that likely comes from the market sniffing out a coming recession,” she explains. “We don’t think it will be caused by a global financial crisis or bubble bursting.”

That means fear levels likely won’t spike quite as high. Investors will also have a better idea of when the bear market might hit, as it will be foreshadowed by signs of a slowing economy.

It also suggests the market will likely rebound more quickly than the average bear of 21 months. As a result, employing basic investment principles, such as portfolio rebalancing, diversification and buying shares on a regular basis, which forces folks to snap up shares when prices are cheaper, can help investors emerge from the next bear market in decent shape.

“Diversification and rebalancing are boring to talk about,” says Sonders. “But they are more useful strategies than all the hyperbole on when to get in or get out of the market, which is not an investment strategy.”

Buy the ‘big’ dips

There are big market swings even in bear markets. A way investors can play it is to buy shares on the days or periods when stocks are under intense selling pressure. “There will be lots of wild swings,” says Mike Wilson, U.S. equity strategist at Morgan Stanley.

Investors have to take advantage of stock prices when they are depressed and present good value, he says, even if it seems like a scary thing to do at the time.

“You have to be willing to step in” when market valuations fall a lot, no matter what’s going on in the world, Wilson advises.

The Market Is Finally Getting the Joke

My Comments: I struggle, day to day, just like you, to figure out what the markets are going to do because so many of my friends and clients are exposed to market risk. Are you exposed to market risk? Does it worry you at all?

If not, you don’t need to read this. But if it does worry you, then perhaps a few minutes reading these comments from Scott Minerd will be good for you. And oh yes, there are ways to shift the risk of a downward correction to an insurance company and by so doing, preserve your principal and market gains from a crash.

Scott Minerd, February 21, 2018

The last two weeks have been pretty exciting, certainly a lot more interesting than anything we’ve been through over the last year. Given the recent market dislocation, there is a basis to rebalance portfolios and do trades to take advantage of relative repricing. At a macro level, it should not surprise anyone that rates have begun to rise—we have been talking about the Federal Reserve (Fed) tightening, we have been talking about how the Fed is behind the curve, how the market has not believed the Fed, and that someday this was going to have to get resolved, probably by the market having to adjust to the Fed’s statements. The market has now gotten the joke. I still don’t think the yield curve is accurately priced, but it is a lot closer today than where it was at the beginning of the year.

The concern, as I explained in A Time for Courage, is that now the market is moving from complacency—where it really did not believe the Fed was going to do what it said it was going to do—to a time when it has begun to realize that the Fed may be behind the curve. The market is now coming to believe that the Fed is not going to make three rate increases this year, it is going to make four. And so, rates start to rise and the whole proposition that the valuation of risk assets is based upon, which is faith in ultra-low rates and continued central bank liquidity, comes into question. As markets lose confidence in that view, investors have started to rearrange the deck chairs by repositioning portfolios.

Anytime we see strength in economic data, we are going to see upward pressure on rates. Upward pressure on rates is going to result in concern over the value of risk assets, and we are going to have a selloff in equity markets, or the junk bond market, or both. Credit spreads will widen. The reality of the situation, however, is that the amount of fiscal stimulus in the pipeline, the U.S. economy fast approaching full employment, the economic bounceback in Europe, and the pickup in momentum in Japan and in China are all real. Against this backdrop, even a harsh selloff in risk assets is not going to derail the expansion.

The Fed knows this, and for that reason the Fed is shrugging its shoulders and saying, “Okay, we don’t have a mandate around risk assets, but we do have a mandate about price stability and full employment. And it looks like we’re at full employment or beyond full employment, and the thing that seems to be at risk now is price stability. We’ve got to raise rates.”

What does that mean for investors? Markets are engaged in a tug of war between higher bond yields and the stock market. In the near term, the two markets will act as governors on each other: Higher bond yields will drive down stock prices, and lower stock prices will cause bond yields to stop rising and to fall.

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“The market is moving from complacency about the Fed to realizing that it may be behind the curve.”

Scott Minerd

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An analogue to today may be 1987. That year began against the backdrop of 1985/1986, which had seen a collapse in energy prices. In 1986 oil prices were very low, and concerns around inflation had diminished. The Federal Reserve had dragged its feet on raising rates. As we entered 1987, in the first few months of the year the stock market took off. By the time we got to March, stocks were up 20 percent. In April there was a hard correction of approximately 10 percent. As fear overtook greed, market participants became cautious on stocks. Going into that summer the stock market rallied another 21 percent from the April lows. By August we were at record highs; interest rates started to move up; the Federal Reserve was raising rates; the dollar was under pressure; and there were increasing concerns over inflation. The concern was the Fed was behind the curve as it accelerated rate increases. By October things were becoming unhinged. Bond yields had risen in the face of an extended bull market in stocks. The market reached a tipping point and began its infamous slide. By the time we got to the end of the year, the stock market for the year was up just 2 percent. That was the stock market crash of 1987, which wiped out about a third of the value of equities in the course of a few weeks.

Today, investors have the same sorts of concerns they had in 1987. For now, the market has gotten a reprieve. Soon, investors will start to have confidence in risk assets again. Risk assets like stocks will start to take off. Eventually, the perception will be that the Fed is falling behind the curve because inflation and economic pressures will continue to mount. Eventually the Fed will acknowledge that three rate hikes will not be enough, but it is going to raise rates four times in 2018, and market speculation will increase that there may be a need for five or six rate hikes. That will be the straw that breaks the camel’s back.

This is a highly plausible scenario for this year, but who knows how these things play out in the end. The reality today is that the economy is strong, interest rates are rising, and equities look fairly cheap. The Fed model right now would tell you the market multiple should be 34 times earnings. That is just fair value, not overvalued. And based on current earnings estimates for the S&P this year, the market multiple is closer to 17 times earnings. If stocks go down by 10 percent, the market multiple would drop to 15 times earnings. This would be getting into the realm of where value stocks trade. If there were a 20 percent selloff, you’re at a 14 times multiple. These market multiples don’t make sense. Markets do not price at 14 times earnings in an accelerating economic expansion with low inflation.

Here’s Why Markets Will Head Downward

My Comments: Now that I’m in my mid 70’s, I’m far more worried about the ups and downs of the markets than I was 15-20 years ago. My ability to pay my monthly bills shrinks exponentially when the market crashes and my retirement money is exposed to that risk.

Ergo, I either do not have much money exposed to that risk, or I’ve repositioned it such that if there is downside risk, I’ve transferred that risk to a third party, ie an insurance company. You should consider doing the same.

BTW, QE means ‘quantitative easing’ and refers to the approach by the Federal Reserve to lower interest rates and to keep them low. That has  ended since the Fed is now slowly raising interest rates.

Clem Chambers,  Feb 12, 2018

I’m completely out of the markets in the U.S., Europe and the U.K. It seems as clear as it can be that the market is in for a huge down.

Now there are permabulls and permabears and if you read my articles over the years calling higher highs in the Dow you might think I am a permabull. But I am not, and if you hunt enough you will find my articles calling the credit crunch back in 2006-2007 here on Forbes and again the post crash bottom to buy in.

I can, and do, go both ways.

It has to be said, calling the market tops and bottoms is a tricky business and you can’t always be right, but there is only one thing you need to know and only one thing you have to know when investing and that is, “which way is the market going. ”

It sounds simple, almost asinine, but it isn’t because most people have no view on market direction, or if they do it’s automatically ‘up.’ As such, most people do not know which way the market is going and as such are at more risk that they need to be.

So where are we now in the markets?

Well, here is history:


This is a terrifying chart for anyone who is long.

Why? Well, first off you can see the very characteristics of the way the market moves have changed for the first time in years. Up close it’s even clearer:

The market has been going up like an angel for a year, the volatility has fallen to nonexistant. Forget the tendency for the price to go parabolic, it’s the day to day footprint of the price action that’s even more important here. Now this style has broken. Something has smashed the dream.

This giant burst of volatility tells us that there is huge uncertainty in the market.

So ask yourself what that involves?

It involves a change of investment environment and the participants in the market fighting that change.

“Buy the dip” is the brain dead mantra that has harvested lots of profits through the era of QE ever-inflating stock prices. What if that stops working? The crowd ‘buys the dips’ but the negative environments rains on that parade and the market begins to shake as the two conflicting forces meet.

Who do you put your money on? The crowd or a new market reality?

I bet against the crowd every time; you cannot fight market systemics.

So what is this new reality? What is causing this? The pundits are unclear, spouting all sorts of waffle that would have been true last year but weren’t and must somehow now be the reason.
Amazingly, few can see the obvious. Where are the headlines?

QE made equities go up. Does anyone disagree?

‘Reverse QE’ is making it go down. Reverse QE is where the Federal Reserve starts to sell its bond mountain for cash. It pushes up interest rates, it sucks money from the economy and straight out of the markets.

Is that ringing any bells?

Reverse QE started in September and month by month is ratcheting up. By next September it will hit $50 billion a month from the starting point in September of $10 billion.

The market is crashing because reverse QE is biting and it is going to bite harder.

There is trillions of dollars of reverse QE to come. Years of it.

Now I suppose it is hoped that U.S. fiscal loosening, tax cuts and overseas profitability repatriation will counterbalance this huge liquidity hit, but for sure this new cash will not flood straight into equities. I’m sure a strong economy is meant to pump liquidity into the loop via profits too, but will these do anything but hold the stock market at a flat level for many a year?

However, this is ‘unorthodox monetary policy’ in reverse. Do you remember when QE was called ‘unorthodox?’ Well, we are back in unorthodox territory again and this is not the happy slope of the mountain of cash, this is the bad news bloody scrabble down the other side with trillions of less money all around.

Somehow this ‘unorthodox’ unwinding of liquidity is aiming for a smooth transition. Well, they are going to need good luck with that and it looks like the process is having a rough start.

So reverse QE could stop. The Fed could halt the program. However, it seems unlikely they would pull the plug on the whole program that fast and then what? First they’d have to take the blame for crashing the market, then they would have to tacitly admit they are stuck with mountains of debt that they will have to roll forever.

That means reverse QE is going to have to punch a far bigger hole in the market than we have seen before it hits the headlines. So where is that? 20,000 on the Dow, 18,000?

Well that’s my feeling, which is why I am cashed up.

So take a look at the chart and remember that reverse QE is here and until further notice the Fed is shrinking its balance sheet, which means one thing… The market is going down.

All of a sudden knowing which way the market is going doesn’t seem so asinine.

History says the bull market is ending

My Comments: Paranoia is an elusive thing. Just because you’re paranoid, it doesn’t mean there’s no one out there intent on putting you down. It’s much the same with the stock market. Just because we’ve not had a market correction now for almost nine years, it doesn’t mean there is one just around the corner. Or does it?

I’m writing this in an attempt to justify my position that for the past three years, I’ve been warning clients and whomever will listen that a market correction of significance is ‘just around the corner’. Is it paranoia or is it real?

Personally, I hope it happens soon. That way we can get over it and move on for the next several years. I just want to be able to start the next upturn from a higher point than the depths of the next collapse. How about you?

If you want a way to participate in the inevitable upside and avoid the inevitable downside, reply to this post or send me an email. I have an answer for you.

(This comes from http://stansburychurchouse.com)

If history is any guide, the good times are about to end for the U.S. stock market.

It’s been one of the longest-running bull markets ever…

Over nearly nine years, or 105 months, the S&P 500 has returned 368 percent (including dividends).

That’s the second-longest bull market the U.S. has ever seen… just behind the nearly 9.5 year-long, or 113 months, bull market that started in 1990.

You can see the S&P 500’s past bull markets in the table below… it shows the date they began, their overall return and how long each lasted. On average since 1926, bull markets have lasted for 54 months, and resulted in returns of 160 percent.

After the 2008/2009 global financial crisis, interest rates around the world plummeted. In the U.S., the Federal Reserve cut interest rates from over 5 percent to zero in the course of just over a year.

Coupled with that, we saw an unprecedented surge of money printing as the Fed expanded its balance sheet (by creating money and buying assets) from a little over US$800 billion to over US$4.4 trillion today, along with a wholesale bailout of the banking system.

We also later have seen a “Trump rally” where investors expected President Donald Trump’s tax reform and infrastructure investment election promises to boost the economy.

But the gains can’t go on forever

Take a look at the following chart. It shows when and why each of the bull markets above eventually ended.

For example, in 1990, the U.S. market entered its longest-running bull market on the back of the Internet boom. The S&P 500 soared over 400 percent in nine years. But in March 2000, the market peaked – and went on to fall 49 percent over the next 2.5 years.

In 2002, the market soared back. It went up over 100 percent in five years. Then the global financial crisis hit in 2007, and the S&P 500 fell 57 percent over the next 17 months.

The bull market/bear market cycle keeps repeating… thanks to mean reversion. Markets (along with most other things in life) tend over time to reverse extreme movements and gravitate back to average.

It’s like a rubber band… stretch it and when you let go it returns to its original shape. So after a period of rising prices, securities tend to deliver average or poor returns. Likewise, market prices that decline too far, too fast, tend to rebound. That is mean reversion, and it works over short and long periods.

And mean reversion isn’t the only reason we think the U.S. bull market is winding down…

Overpriced equities

By many measures, U.S. stock market valuations are high.

One of the best ways of measuring market value is to use the cyclically-adjustedprice-to-earnings (CAPE) ratio. It’s a longer-term, inflation-adjusted measure that smooths out short-term earnings and cycle volatilities to give a more comprehensive, and accurate, measure of market value.

As the chart below shows, the CAPE for the S&P 500 is now at 33.6 times earnings. That’s higher than any time in history, except for the late ‘90s dotcom bubble. It’s even higher than the stock market bubble of the late 1920s.

High valuations don’t mean that share prices will fall. High valuation levels can always go higher, at least for a bit. Or they could stand still for a while. But mean reversion suggests that at some point, valuations will fall, one way or the other.

And as we showed you recently, the U.S. economy could also be about to see a slowdown in growth – which could also dampen market sentiment and hurt share prices.

It’s not just the U.S.

Now, this is all in the U.S. But we’re seeing a similar situation in global markets.

As we told you in November, the MSCI All Country World Index (which reflects the performance of global stock markets) has seen an unprecedented streak of gains over the past year. And it’s up 8.4 percent since we last wrote about it. As we said earlier, nothing goes up forever.

Plus, if the world’s biggest market (at around half of the global market cap) is in trouble, the rest of the world could be too.

So what should you do?

Look to diversify your portfolio. Regular readers will know that we’re big fans of diversification.

We’ve written before about the importance of not just investing in different sectors and asset classes… but in different markets and countries too. That’s because spreading a portfolio around the world reduces risk. After all, gains in one market can offset losses in another.

And while the gains in some markets are nearing an end, they’re just getting started in markets like India, Bangladesh and Vietnam. These are three of the fastest-growing markets in the world.
So do yourself a favour and diversify your portfolio.

Read the original article on Stansberry Churchouse Research. This is a guest post by Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free. Copyright 2018. Follow Stansberry Churchouse Research on Twitter.

The Perfect Storm (Of The Coming Market Crisis)

My Comments: We do not live in a perfect world. Flaws are all around us. As responsible adults, we always try to make good decisions, and mostly we succeed. Until we don’t.

If you expect to live another 20 or 30 years, the money you’ll need to pay your bills has to come from somewhere. If you’ve already turned off the ‘work for money’ switch and retired, you’re dependent on work credits and saved resources. Maybe you have a pension that sends you money every month. Good for you.

If you are still working, you’re probably setting aside some of what you earn so you can someday retire and get on with the rest of your life without financial stress. At least that should be your plan.

This article from Lance Roberts, a professional money manager, needs to be read and understood. I’m not going to copy everything he says, but I do encourage you to follow the link I’ve put below. Make an effort to understand what he’s telling us. Your financial life may depend on it.

Know also there are ways to shift the risk of loss to a third party. For a fee, you get to enjoy the upside and avoid the downside. If you do live for another 20 – 30 years, where is your money going to come from?

Lance Roberts published this today, November 28th, and it can be found HERE.

Stocks for the Long Run? Not Now

My Comments: There is increasing uncertainty about the stock market. This uncertainty has been growing now for the past 3 plus years. The long term trends described below, coupled with historically low interest rates, suggest the next decade will be disappointing to most of us.

This analysis comes from a Guggenheim Investors report published last September. I haven’t included all the many charts as you will be better served by going directly to the source to see them. https://goo.gl/UL1SSP

If nothing else, you should read the conclusion below…

September 27, 2017 |by Scott Minerd et al, Guggenheim Investments

Introduction

Valuation is a poor timing tool. After all, markets that are overvalued and become even more overvalued are called bull markets. Over a relatively long time horizon, however, valuation has been an excellent predictor of future performance. Our analysis shows that based on current valuations, U.S. equity investors are likely to be disappointed after the next 10 years. While the equity market could continue to perform in the short run, over the long run better relative value will likely be found in fixed income and non-U.S. equities.

Elevated U.S. Equity Valuations Point to Low Future Returns

U.S. stocks are not cheap. Total U.S. stock market capitalization as a percentage of gross domestic product (market cap to GDP) currently stands at 142 percent. This level is near all-time highs, greater than the 2006–2007 peak and surpassed only by the internet bubble period of 1999–2000. This reading is no outlier: It is consistent with other broad measures of U.S. equity valuation, including Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), Tobin’s Q (the ratio of market value to net worth), and the S&P 500 price to sales ratio.

U.S. Equity Valuation Is Approaching Historic Highs

Here is the bad news for equity investors: At current levels of market cap to GDP, estimated annualized total returns over the next 10 years look dismal at just 0.9 percent (before inflation), based on previous trends. Intuitively this makes sense: Looking back at the history of the time series, it is clear that an excellent entry point into the equity market for a long-term investor would have been a period like the mid-1980s, or in the latter stages of the financial crisis in 2009. Conversely, 1968, 2000, and 2007 would have been good times to get out.

Market Cap to GDP Has Been a Strong Predictor of Future Equity Returns

Market cap to GDP is a useful metric because it has proven to be an accurate predictor of future equity returns. As the chart below shows, market cap to GDP has historically been highly negatively correlated with subsequent S&P 500 total returns, particularly over longer horizons where valuation mean reversion becomes a significant factor. Over 10 years, the correlation is -90 percent.

Market Cap to GDP Has Been a Good Predictor of Equity Returns 10 Years Out

It would be easy to assume that the rise in stock valuations is justified by low rates. A similar argument is made by proponents of the Fed model, which compares the earnings yield of equities to the 10-year Treasury yield as a measure of relative value. While there is some relationship between interest rates and valuation as measured by market cap to GDP, low rates do not explain why equities are so rich. At the current range of interest rates (2–3 percent), we have seen market cap to GDP anywhere from 47 percent to current levels of 142 percent—hardly a convincing relationship. In short, interest rates tell us little about where market cap to GDP, or other valuation metrics, “should” be.

Fixed Income Offers Better Relative Value

For a measure of relative value, we compared expected returns on equities over 10-year time horizons (as implied by the relationship with market cap to GDP) to the expected return on 10-year Treasurys—assuming that the return is equal to the prevailing yield to maturity. Typically, equities would have the higher expected returns than government bonds due to the higher risk premium, but in periods when equity valuations have become too rich, future returns on U.S. stocks have fallen below 10-year Treasury yields. Not surprisingly, past periods where this signal has occurred include the late 1990s internet bubble and 2006–2007.

The chart below demonstrates that if equities over the next 10 years are likely to return just 0.9 percent, 10-year Treasury notes held to maturity—currently yielding about 2.2 percent—start to seem like a viable alternative. The fact that S&P 500 returns over the past 10 years have not been as low as the model predicted can at least be partially explained by extraordinary monetary policy, which may have helped to pull returns forward, but in doing so dragged down future returns.

Conclusion

Based on the historical relationship between market cap to GDP ratios and subsequent 10-year returns, today’s market valuation suggests that the annual return on a broad U.S. equity portfolio over the next 10 years is likely to be very disappointing. As such, investors may want to seek better opportunities elsewhere. Equity valuations are less stretched in other developed and emerging markets, which may present more upside potential.

In fixed income, low yields should not deter investors, as our analysis indicates that U.S. Treasurys should outperform equities over the next decade. But as we explained in The Core Conundrum, low Treasury yields should steer investors away from passively allocating to an aggregate index that overwhelmingly favors low-yielding government-related debt. In particular, sectors not represented in the Bloomberg Barclays Aggregate Index, including highly rated commercial asset-backed securities and collateralized loan obligations, can offer comparable (or higher) yields with less duration risk than similarly rated corporate bonds. We believe active fixed-income management that focuses on the best risk-adjusted opportunities—whether in or out of the benchmark—offers the best solution to meeting investors’ objectives in a low-return world.