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By Christine Benz | 10-13-2011 12:37 PM

Vanguard's Davis: What We Expect for Market Returns

Even given muddled economic growth expectations in the developed world, longer-term expected returns for stocks are not outside of historical norms.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

I recently sat down with Joe Davis, chief economist for the Vanguard Group. He discussed his market outlook as well as his views on the economy.

Joe, thank you so much for being here.

Joe Davis: Thank you Christine, pleasure.

Benz: You look at various asset classes and attempt to come up with forecasts for what they might return in the years ahead, and I understand that you've recently taken a look at U.S. equities in particular and ratcheted down your expectations a bit. Let's talk about, first how you arrive at those forecasts, and second, what you're thinking in terms of returns from the major asset classes?

Davis: So, in terms of how we approach the problem here at Vanguard, [we're] very interested in looking at what is a reasonable set or distribution of returns for various asset classes that you mentioned. Again, a key point of distinction is, we are really focusing on a distribution. It is not a point or one number. But when we would look at that, one of the key drivers for equities over long periods of time, we tend to really focus on 10, 20, 30-year horizons, because that's where there is modest predictability, and when we look at those horizons, valuation metrics--P/E ratios, price-to-book, other measures--are a key figure in that.

So, over the course of the past year or two, some of those longer-term expectations have come down at the margin, but they are still, more likely than not, closer to history, the 1926-on expected return for equities, as a central tendency, which can seem somewhat counterintuitive, when we hear and which I think is reasonable, somewhat lower muddled economic growth in the developed world going forward. And again, a key point that we tell investors is, much more important for long-term investing is not the economic growth per se of what is expected. Much more important is the price one pays for growth. And just to push the analogy, if it was only growth that mattered then say growth stocks would always outperform value stocks and that certainly hasn't been the case over long periods of time.

Benz: Right, right. So, with today as a starting point and looking at valuations, what sort of range of returns might be realistic for investors to look around?

Davis: So I think our range of returns, I mean, it depends how much confident one wants to be in terms of making sure if one is in that range, to a be 100% confident, you have a huge range.

When we are talking about 25th to 75th percentile, it's something in the 4% to 12% range, which is still wide, but you know there is this natural question of lower fixed-income yields, so hence lower expected returns, greater volatility that we've seen recently in the markets. So, the natural question is, is the asset allocation problem, is it different in some meaningful way?

I think we can talk about some of the shifts in the expected return frontier, but the fundamental properties of strategic asset allocation, in our mind, have not changed--which means what? For a more conservative portfolio, perhaps move into more aggressive, higher-expected risk, higher-expected return.

So, I think it's that trade-off that we have always had to grapple with as investors, and that's still inherent and expected going forward. So, I think, broadly speaking, we've taken a step back, how we approach the strategic asset allocation problem is unchanged for the foreseeable future.

Benz: Now, is there any nuance in terms of your analysis among sub-asset classes, so international versus U.S. for example?

Davis: So we will look at expected ranges of expected returns for U.S., other developed markets, and then emerging markets. And then on a strategic basis, although those central tendencies can move around from month to month at the margin, there is really no meaningful expected return difference between U.S. markets and other developed markets.

There is a slight expected return differential at the margin for emerging markets, but again, that is in part because they anticipate higher volatility of an emerging market portfolio. So, there would be some expectation for compensation for that, but I wouldn't call the differences in the central tendencies as economically or statistically meaningful.

Benz: Okay. So, for fixed income, do you use current yields as sort of a proxy for what investors might expect from bonds in the future?

Davis: We do. Again, critical to our analysis is that initial conditions do matter, and for fixed income they are critical as you mentioned, Christine. And we do look at what potential evolution of the yield curve is, as well as corporate spreads and other risk factors in the bond market. But when you look at that, a yield-to-maturity on a bond portfolio still remains to this day, all math aside, or all tools aside, it's a reasonable return expectation, central tendency for a bond portfolio. So, I don't think there is any getting around some of the bond math that we have lower expected returns given the fact that returns have been so stellar over the past two, three years.

Benz: And driven by declining rates, too.

Davis: Declining rates. But again I think this one from a thematic approach. I think in terms of investors, what we're going to continue to hear are questions around or just conversations going around, where do I go for income? Is it still bonds? Yes, answers both fronts, but the return stream is just going to be lower. It could be more volatile at times, too, but I think this conversation around dividend yield paying stocks versus fixed income probably will be more accentuated today and in the next two years than it has been probably over the past decade.

Benz: So, another thing I want to touch on Joe: you and your team did some research where you looked at the performance of a balanced portfolio during varying economic conditions, both recessionary and more expansionary, and I'd like you to tell us what you found, because I do think it's pretty counterintuitive?

Davis: So, what we found is that on average, the return on a balanced portfolio, whether adjusted for inflation or not, has been effectively similar or almost identical between periods of recession and expansion. As we all know, the U.S. economy has been one or the other. And again that does seem very counterintuitive. Part of that is because during recessions, what happens in a balanced portfolio? More often than not, there is a flight-to-quality effect for bonds, which can help offset the initial loses in equities.

The second effect, which is what I would call a leading indicator effect, the equity market is being one of those leading indicators, tends to fall, perhaps even into bear market territory long before it's officially recognized as a recession, and then by extension and by definition tends to rebound long before the recession is officially over, and this happened as recently as early 2009, several months before the recession officially ended.

So, I think again, to my mind and our minds at Vanguard, it's the testament to broader diversified long-term perspective--it's not that one would wish that recessions occurs or that we're indifferent as citizens that a recession occurs, but it's much more of why staying the course and having a balanced long-term perspective is critical. And I think this is just a great Exhibit A of why not paying over-attention on near-term economic events can serve investors well.

Benz: For people right now, then, looking at, what seems to be perhaps a flat-lining economy, it seems that from this research people shouldn't be overly concerned or inclined to be overly defensive at this juncture?

Davis: I would totally agree with this point, Christine, but as you mentioned, that could seem very counterintuitive, and that's I think understandable given the information that we just have to digest. I think that when you take a step back, you said very little if any growth. We have similar expectations in the near term. Now where are those expectations coming from? We have found it most useful to look at what the financial markets themselves--the bond market, the stock market--what are the economic growth scenarios that those markets are pricing in? And it's by those measures that give us some of these estimates of what a recession are.

So, it's a key point to keep in mind. So in other words, the market is already pricing in, so to speak, at a high level, very little or close to zero growth, which means then to react to, if one hears, we're going to recession, have near-zero growth, I think then to react to one's portfolio is again we would have to keep in mind that you are reacting to the very markets themselves, to adjust to those markets, that's something that one wants to just think twice about before one proceeds.

Benz: You may be late with that.

Davis: Yes, late.

Benz: Thank you so much, Joe. This is really helpful research. I appreciate you sharing with us.

Davis: Thank you, Christine. My pleasure.

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