Investing Specialists

Your Forecasts for Stock and Bond Returns

Christine Benz

In a recent interview at the annual Bogleheads conference, I asked Vanguard founder Jack Bogle to share his outlook for stock and bond returns over the next decade, figures that he arrives at by using a very commonsensical approach.

Assuming a 2%-plus dividend yield, earnings growth rates of 5% or 6%, and current P/E ratios, Bogle said it's reasonable to expect stock market returns in the range of 7%. Bogle, like many market watchers, is less sanguine about bond-market returns, noting that currently meager Treasury yields predict similarly meager future returns. He noted, however, that investors can reasonably increase their fixed-income returns by taking on slightly more interest-rate and/or credit-quality risk with a component of their bond portfolios.

With that forecast still fresh, I asked users to weigh in on what sort of return forecasts they're using for their own portfolios. Given that many Morningstar.com readers focus on bottom-up security selection more than broad-market forecasting, it wasn't surprising that a healthy contingent responded to my query with a "Who knows?" But other posters weighed in with their views, some aligning with Bogle and others arguing that stock returns will be richer or poorer than the 7% Bogle anticipates. To read the complete thread or share your own market forecast, click here.

'He Has Been Right in the Past'
Several posters put a fair amount of weight on Bogle's forecasts, in part because his track record is pretty darn good. (He correctly anticipated the robust market gains that prevailed in the 1990s as well as the feeble returns of the previous decade.)

LarryGo aligns with Bogle's stock-market predictions, in part because of the indexing guru's past track record and also because they sync up with his views on the economy. "I would trust Mr. Bogle's forecast. He has been right in the past. U.S. stocks are pretty much where they were about 10 years ago, and maybe it's because they had been excessively run up in the '90s. U.S. corporations are today sitting on over a trillion dollars in cash, and are very lean. There will be a drag in the U.S. economy because of the debt burden of the Western economies; however, this will be offset by growth in the global economy. Plus, insiders have been buying U.S. stocks, which is a good indication that stocks are under- or fairly valued."

Counterpoint's estimates for equity-market returns are in the same ballpark as Bogle's, but with the potential for an "upside surprise." "I budget 7% for stocks but I think there is a greater chance of a positive surprise than a negative one. Better to plan reasonably and be pleasantly surprised."

Academic noted that other wise market forecasters are anticipating returns in the same general ballpark as Bogle's. "The latest projections from Jeremy Grantham at GMO for seven-year annualized returns are +5.6% nominal (3.1 % real) returns for U.S. large-cap stocks and +1.3% nominal (-1.2% real) returns for U.S. bonds. This is quite similar to Bogle. John Hussmann comes to similar conclusions. These three are smarter and have thought a lot more about this than me. So I'll be completely unoriginal and project 6% nominal for U.S. stocks, and 2% nominal for U.S. investment-grade bonds over the next 10 years."

DaveD82 looks to a model developed by Richard Grinold and Kenneth Kroner, writing, "I think the Grinold and Kroner model holds some validity for broad market equity return expectations:

Expected Returns = Dividend Yield + Real Earnings Growth + Inflation + Change in shares + Change in P/E Multiple

~ 2% + 3-5% + 2-3% + ? + ?

Without making more broad assumptions than one needs to, you could expect 7%-10% annualized returns."

Nittwit, while noting that the stock and bond market returns don't lend themselves to the mathematical modeling one needs to develop a forecast, wrote, "In this case equity markets are likely to earn more than the bond markets over a long (3 years or longer) time. So I will use Jack Bogle's 7% equity and 2%-3% bond returns. I will not cry if the markets don't yield his predictions; Mr. Bogle has done all investors a great service with his invention of index funds and pushing of low-cost investing."

'Large Lumpy Ups and Downs'
Other posters, meanwhile, varied significantly from Bogle in their outlooks for equity-market returns.

Tricepz3 was a rare poster who's operating with a truly bullish forecast, noting, "I believe after the 'Lost Decade' we have experienced with equity returns well below the historic average, the S&P will return 10%-12% over the next 10 years, with current decent yields and low expectations. The beginning of the next great bull market is somewhere just over the horizon. Most balance sheets are pretty solid, many companies are bursting with cash, costs are leaner and meaner than ever. After the 1987 crash, John Templeton predicted that America's GDP would be 64 times what it was then within forty years. Mr. Templeton was no wild eyed radical."

Yet a larger contingent of posters was less sanguine, with forecasts ranging from cautious to downright bearish.

Capecod wrote, "I estimate that stock indices will likely return an average of 5-7%-- in large lumpy ups and downs."

JohnCo, too, is less optimistic than Bogle, though he agrees that Shiller P/E, which Bogle used to anchor his predictions, is a valid starting point. "The Shiller P/E (on which Bogle was basing his remarks) has quite a good record of predicting the annualized return of the index for the next decade, but not a good record for predicting one or two years' worth of returns. Now, I happen to think Bogle's 7% is a bit optimistic with the Shiller P/E up around 20x now."

Dragonpat was one of several posters to opine that past excesses will weigh on equity-market returns. "I would like to believe Mr. Bogle, but I don't think so. The developed world has to pay for the 20-year party they have been on, and that involves austerity. Austerity means a lack of spending. especially discretionary spending. We will be lucky if stocks return 5% in the next decade."

Academic is of a similar mind, writing, "I'd also say we're only through about the 5th or 6th inning of working off the excesses of the '00s. On a two- to three-year time frame I expect further trouble in the economy and further episodes of doom and gloom in the markets. One of those episodes would be the time to bet big on stocks. Right now, anything in the range from 50%-65% stocks seems reasonable to me for most investors."

Darwinian is arguably even more downbeat, writing, "My investments are based on recognition that we are in a secular bear market; and based on demographics, this one is likely to last until near the point where the last of the baby boomers retire. This is now a bit more than 10 years out. As in all secular bear markets, therefore, we can expect 10 years of (1) high stock-market volatility and (2) declining P/E and P/B. And, (3) future market peaks, adjusted for inflation, will probably not much exceed those of 2000 and 2007, while (4) future market lows, adjusted for inflation, will probably be lower than those in 2002-03 and 2007."

He concluded, "Any portfolio should therefore contain both fixed-income and stock; should be rebalanced whenever valuations become extreme; and should contain a significant proportion of highly volatile stocks (small-cap and emerging). These will gain more value between the time they are bought and the time they are sold, during rebalancing."

Matthew9 concurred with Darwinian's "secular bear" view, but hopes to gain an edge with security selection. "[W]e are definitely in a secular bear market. I hope to get a 5% return or more over the coming decade. I'll try to do this by owning very well managed companies who have solid balance sheets and preferrably pay a dividend in most cases, but certainly not all. International investments directly and indirectly in equities and owning bonds by well capitalized developing nations will be key."

ChiefK, meanwhile, sees a downside in the fact that companies have a lot of cash on their balance sheets. "Oddly, it's the continued reports that companies are sitting on wads of excess cash that worry me. With all that cash on hand, companies should not have to borrow as much to finance operations and expansion; hence, fewer bonds sold at lower interest rates. [Also, w]ith all that cash on hand, company executives may once again be tempted to overpay to buy out other companies, [resulting in a] potential "deworsification of industries."

Kubrick, too, sees headwinds for the equity market, writing, "I believe we will see negative real returns as this is what is needed to pay off the boomer pensions and for health careā€¦ The next 10 years will not be about stocks or bonds, IMO; it will be all about debt, i.e., recalibration of what the dollar is worth. You may make a 10% return in stock but it will be on the back of inflation alone and will see real negative returns."

Poster WorryWart was perhaps the most bearish of all, forecasting terrible real returns for both stocks and bonds. "I anticipate a near-term grind-down to S&P 800 or 900, followed by a long, slow, volatile muddle-along period without significant real increases. Netting these effects with the average dividend payout of the S&P 500, I foresee 10-year equity returns averaging less than 1% per year. Paired with this scenario I anticipate continued very low interest rates for the next decade, meaning that nominal fixed income returns will hover around 2% or 3%, depending upon the usual variables. I am projecting inflation at an average rate of about 4%, mostly in the areas of food and commodities. Thus, in the aggregate, we should all be taking second jobs, growing 'victory' gardens, and hoping with every fiber of our beings that we and our families remain in good health. Of course, I am the guy who said the blue M&M would never return, so what do I know?"

'A Shattered Crystal Ball'
While equity-market return expectations ranged far and wide, posters generally concurred with Jack Bogle's forecast for muted bond-market returns. Yet posters such as Capecod pointed out that other fixed-income sectors could offer the potential for better returns than Treasuries. He wrote, "Treasuries will probably return 2%-3.5% as the Bogler estimates. However, investment-grade corporates will probably return 6.5%-9%, and high-quality fixed-income closed-end funds containing AA-ish munis, [mortgage-backed bonds], and investment-grade corporates will deliver a far smoother, more reliable, and largely distributed average 8%-10% taxable [return].

Counterpoint shared the view that fixed-income investors who are willing to take on additional risk will be rewarded. "For bonds, you cannot simply say what the return will be like you can for stocks. There are way too many different types of bonds to use a one-size-fits-all return estimate. Nonetheless, I think you will be able to generate good returns in fixed income if you position yourself properly... even in a rising-rate environment (which will eventually happen). Shortening maturities, moving out the risk curve and investing in some long/short funds should get you at least to that 4%-5% range (or the tax-exempt equivalent)."

Other posters pointed out the difficulty (some might say the folly) of attempting to predict market returns.

Before sharing his forecast for a 5%-6% return from the S&P 500 and a broad range of returns for bonds over the next decade, TheDumberOne quipped, "As Yogi Berra said: it is hard to forecast, especially the future."

FidlStix also pointed to the difficulty of getting market calls right. "I dropped my crystal ball on my foot the other day. Now I have a fat toe and a shattered crystal ball. The thing was no good for anything, anyway. I think 'predicting' gains for the next decade is fun but of little real value. New forces are gaining ascendency in the markets--among them flash trading and ETFs. These forces are ushering in even more uncertainty than we've seen before."

Academic, too, included a caveat along with his forecast. "I think the smartest bet is not to make a big bet based on these numbers. The market routinely makes fools of smart people. These projections could easily be very wrong."

Beingcareful, for one, believes that controlling those variables you can and using conservative return estimates is the best way to reach your financial goals. "I don't have a forecast. I've returned to investing at 77 with new money from a home sale. I've worked out a worst-case scenario for living expenses should one of my pensions fail, and found that an overall 5% return will be enough. I'm invested in Vanguard Wellesley (VWINX) and Wellington (VWELX), along with a few bond funds (short, mid, and TIPS). Other than holding a few dividend stocks to keep an eye on the market, I'm leaving investment decisions and projections to the fund managers."



30-Minute Money Solutions





Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar Director of Personal Finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more.


Reserve Your Copy Today--$16.95
Publishes January 2010







Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.