Preparing for Lower Long-Term Returns

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How should the market's valuation inform your portfolio's positioning? Joining me to discuss that question is Michael Kitces. He is a financial-planning expert.

Michael, thank you so much for being here.

Michael Kitces: Thanks for having me back.

Benz: Investors often grapple with what specific factors might be predictive of future market performance. They might look at economic growth. One thing that some academic literature seems to support is that current market valuations are somewhat predictive of the returns that you're likely to expect.

Kitces: There has been some interesting growth in the research out there of what really predicts long-term returns. And as you know, ironically--notwithstanding all the headlines about it--it turns out that things like GDP growth in the last quarter has almost no actual predictive value for markets over any useful time period. Certainly, in the aggregate over a multidecade time period, how much the economy growth matters, but it has nothing in the way of actual predictive value.

Valuation is kind of an interesting one, though. What we're finding more and more from valuation is that it's actually still not very good at telling you what's going to happen with the markets in the next six or 12 months and where they are going in the near term. But it's perhaps better than we give it credit for in how much it actually predicts long-term market returns. I suppose in some way the recent research on this really just goes back to Benjamin Graham almost a hundred years ago, who noted that, in the short term, markets act like a voting machine; in the long term, they act like a weighing machine. In the long term, valuation eventually comes to bear and either lifts up returns if things are cheap or drags down returns when they are more expensive.

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Benz: So, when you look at various time periods over which valuation tends to be most or least predictive, you said in the short term it's not so predictive, while over longer time periods it is. But very long time periods, again, maybe not so effective.

Kitces: It starts to break down. So, we've looked at lots of different valuation measures of this question of what works. Ironically, some of the ones that are most popular that we talk about most often really don't work very well. Things like forward-looking P/E ratios tend to be very poor at predicting market returns over really much of any time horizon because, unfortunately, we just tend not to get forward earnings correct. Particularly in market returns, we usually don't see the recession coming until it's too late, and then we tend to overestimate the declines and underestimate the turns when they come. So, we find that forward P/E ratios don't work very well. Things like earnings over the past year are a little bit too short term.

The measures we find that work the best are those like the Shiller P/E ratio. It's often called cyclically adjusted P/E ratios, or CAPE, where we actually take 10 years' worth of trailing earnings, adjust them for inflation, and average them out over that whole time period. So, we get something that's kind of smoothed out for all the volatile market cycles, and that turns out to actually have some very powerful predictability of future market returns; but as you said, it's only over longer time periods.

When you look over a time horizon like a year, it turns out that Shiller CAPE is only slightly more predictive than monkeys throwing darts at stocks. It's almost random. It's ever so slightly better, but it's almost random. As the time horizon stretches out, though, it becomes much, much better, and there is actually an incredibly high correlation between Shiller market valuation and returns over the next eight years or so. It's actually quite good, and it explains almost half the variation in eight-year returns. So, it doesn't necessarily tell you how you're going to get there over eight years--it just says that from high valuation points, the market returns tend to be worse over eight years and then from low valuation points, they tend to be better.

When we inflation-adjust the data--looking at real returns instead--Shiller P/E ratios actually get even more predictive, but the time horizon gets longer. It's almost twice as long. So, we find out that Shiller P/E ratios are actually quite good at predicting things like 15-year real returns in equities--which ironically tells you very little about how to invest your portfolio right now. But it tells you a whole lot when you are trying to make decisions like how much can I safely spend from my portfolio, how much risk do I want to take overall in the next decade, and do I even have enough money to retire? Those sorts of questions are greatly impacted by market valuation.

Then, when we stretch the time period out even further, it actually starts to break down again. So, we've seen a lot of people say things like, "I'm just going to drag all my retirement spending way down because it looks like the 30-year return on the market has to be bad if valuations are so high." But we actually find that the predictability of valuation for 30-year returns is hardly any better than it is for one-year returns. So, one year is too short--markets happen because they are a voting machine; 30 years is actually too long because whole economies can restructure themselves over 30 years. We really find it's that eight to 15-year time period where it's really powerful, which matters a lot for, say, retirees thinking about sequence-of-return risk and accumulators who might be in their 40s or 50s and could be 10 or 15 years away from retirement and are trying to figure out whether the market is likely to cooperate with their portfolio growth and getting them to the finish line. But you have to be careful not to either focus too short or too long.

Benz: So, let's talk about what that Shiller cyclically adjusted P/E is saying today and then get into what would be the implications for investors who have a time horizon of, say, 10 years or longer.

Kitces: So, unfortunately, the news today for Shiller P/E ratios is not good. We're not quite at extreme no-sleep levels. We are nowhere near where we were back in late 1999 or early 2000. But we are in that upper 10% to 20% range of historical values, which have traditionally been associated with much lower investment returns. If we look at real returns on average, historically, equities have done somewhere between about 6% and 7% real returns. Unfortunately, when we look at starting in high-valuation environments, the average has been closer to 2%. So, it's a pretty dramatic haircut--like 3% to 4% lower long-term real returns in stocks when we start in these high-valuation environments.

Now, it's not a zero--it's not a negative number. It doesn't mean that, therefore, you should sell out of all equities, but it means when we are trying to make decisions--when you're trying to figure out whether you are going to be on track for retirement--it suggests that you might end up needing to save a little bit more or work a little bit longer. And if you're retired and spending money, particularly in the first half of retirement, it suggests you might want to be a little bit more conservative--both in your portfolio allocation and in your spending levels--just recognizing that the next decade isn't necessarily going to be very good.

Now, ironically, what we also see in the data is that this really does tend to move in cycles. In a bad instance, by the end, valuation gets so cheap that the next 10 to 15 years often is very good. So, I guess the small silver lining for this is that although it suggests market returns may not be great from now through the end of the 2020s, the 2030s and 2040s could turn out to be a very good time to be an investor. And again, that means the 30-year time period may actually be quite reasonable. But it certainly suggests lower returns over the next 10 or 15 years, and there really isn't any place to hide--those low returns tend to be across the board. But it means you might be a little bit more defensive overall because, of course, if we're not getting rewarded as much for the upside, it doesn't pay as much to take the same kind of risk. And it means, again, you might need to save a little bit more, spend a little bit less, and just be a little bit more defensive in your posturing.

Benz: I know we're not talking about fixed income here directly, but I think some investors might think, "Well, you're telling me to maybe emphasize fixed income at a time when it's hard to see that as a particularly appetizing asset class."

Kitces: Part of this is just the challenge of being in a low-return environment. Having low yields arguably is one of the things that's actually let equity valuations get as high as they are. But all that really means is, good news, you can get 2% in dividends on your stocks, which looks nice compared with getting zero or 1% in your short-term fixed income. But we're still choosing between dividends of 2% and fixed-income yields of less than 2%. This is still kind of like asking, "Do you want your low returns or do you want your low returns?" Because these all tend to move together.

The risk, frankly, I think, for equity investors, though, is first and foremost your returns might still look appealing over fixed income, but unfortunately your downside is the same that it always is--which is what happens when bad things happen in markets. They can fall 30% or 40%. So, at least if I'm getting a long-term historical equity-risk premium of 6%--or if stocks are cheap and I can get more than that--I'm willing to take a 30% or 40% drawdown to get to 6%, 8%, or 10% real returns in the long run.

It's a little bit less appealing to risk 30% or 40% drawdowns when you might only get 2%, 3%, or 4% real returns in the long run. You're not getting paid as well for the risk that you're taking. And that doesn't necessarily mean you're going to run to fixed income because it's going to give you great returns. It means you might shift a little bit more to fixed income because you're just trying to buffer the downside in what's an overall low-return environment. Unfortunately, with the environment we're in, none of the cards we're getting are very good. So, it's not about trying to pick stocks because they are better than bonds or picking bonds because they are better than stocks, per se. It's if stocks are the risky thing and not giving you much bang for your buck--if you're not getting a lot of equity-risk premium out of it--it may just not pay to take the risk. You're frankly going to go from one lower-returning investment into another to wait because bonds are still a safer place between the two. Even if rates start going up, bonds in a rising-rate environment still don't lose nearly as much as stocks in bear markets.

Benz: Investors might also be inclined to maybe tinker with their equity exposure a little bit, maybe to tilt toward parts of the equity market that may look cheaper.

Kitces: Absolutely. We can look at this in two dimensions. There is the absolute-valuation level--determining whether something looks expensive relative to historical standards and investment norms, which unfortunately suggests equities are at least a little bit high right now as an overall asset class. But absolutely, we can look within those and say maybe equities are high overall, but maybe I like large cap more than small cap because I'm concerned small cap is even worse, or maybe I like emerging markets a little bit more because I actually think they are a little bit cheaper than domestic markets. Obviously, those dynamics change over time as well.

So, it's certainly true that we don't have to look at this as just a single block--equities in one big bucket. We can and actually do drill down to a much deeper level as we go through our own investment process in looking at particular segments of the equity markets--particular sectors, capitalization sizes, domestic versus international--in trying to make those decisions about what's got at least a little bit more or less relative appeal, one versus the other, as well as just how much absolute appeal is there in equities versus fixed income or other alternatives.

Benz: Michael, in a market that may not be cheap, those are some valuable insights. Thank you so much for being here.

Kitces: My pleasure. I hope it helps.