September 30, 2023
After a stellar first half of 2023, the third quarter of 2023 saw losses in most U.S. stock asset classes, and even more significant losses in many U.S. real estate-related asset classes. Despite a dismal September, for the quarter foreign developed markets and emerging markets fared generally better. While there are many reasons for the downturn in U.S. stocks, one factor may be the high current valuation levels of U.S. stocks – in particular U.S. growth stocks.
In this issue of Perspectives I again look at the expected long-term returns of certain asset classes. I suggest that an investment strategy involving the use of selected “factors” (value, profitability, growth) in equity investing, both for U.S. stock markets as well as (on a diversified basis) foreign developed markets and emerging markets stocks, possesses a substantial statistical probability of outperformance – relative to U.S. large company stocks, and in particular U.S. large company growth stocks – over the next 10 years or longer.
High Valuation Levels Continue for U.S. Large Company Stocks
An interesting data set is from Professor Robert Shiller, who has put together the annual returns of the Standard & Poors’ 500 Index® for over 100 years for U.S. large company stocks. Generally, today, these are stocks of companies in which the total value of all issued common stock of the company is worth $10 billion or greater.
A question we can ask is how well the valuations of this index, as measured by a valuation metric such as price-to-book value, reflects the expected returns of the index, over the long term. The chart below shows, on the left axis, the Cyclically-Adjusted Price-Earnings Ratio (using the preceding 10 years of data) for large company U.S. stocks (as represented by the S&P 500 Index) relative to (on the bottom axis) the subsequent 20-year inflation-adjusted cumulative returns of the S&P 500 Index.
Data from Robert Shiller’s web site and DFA ReturnsWeb/Standard & Poors. Past performance is not a guarantee of future returns. The chart data presents index returns, and no deduction is undertaken for fees incurred in connection with investing, such as the fees and costs of mutual funds or exchange-traded funds (ETFs) (including internal transaction costs from trading of securities within a fund, opportunity costs arising from cash holdings). Nor is any deduction taken for investment advisory fees charged by Scholar Financial, LLC or any other investment adviser. For educational purposes only.
As seen from the chart, when valuation levels are high – with the CAPE10 ratio at or above 30, the subsequent 20-year inflation-adjusted returns of the S&P 500 Index tend to be quite low.
If valuation levels are low – with the CAPE 10 at 25 or less, there is a wide disbursement of the returns data. While there does exist 20-year periods when returns are quite low, there are also periods of time when the cumulative total returns of the index are quite high.
Note that in every 20-year period surveyed (e.g., calendar year periods ending from 1945 through 2022), the real return (i.e., the return of the index, less inflation or plus deflation) was positive.
As of the close of trading on September 29, 2023, the Shiller CAPE10 Ratio for the S&P 500 Index stood at 29.48, which is well above the historic mean level of approximately 17 and the historic median level of approximately 16. While commentators note that changes to tax laws affecting the reporting of corporate earnings, and other factors, I suggest that a “normal” CAPE10 Ratio may fall within the low 20’s today, even then the ratio is quite high.
Chart is from www.multp.com. Data represents index valuation levels, as measured by the Shiller CAPE10 ratio, for the S&P 500 Index. You cannot invest directly in an index. For educational purposes only.
Where Does This Leave Equity Investors?
The investor who invests only in an S&P 500 Index Fund (which holds large company U.S. stocks), or even a “total stock market” U.S. stock fund (which typically consists of 80% or greater large company U.S. stocks), is likely to possess low returns over the next 10-20 year period, relative to historical returns for this asset class.
At the same time, investors who utilize the size (small cap), price (value), and high profitability factors, especially with the employment of multi-factor funds, possess a statistical advantage, as the valuation levels for value stocks (especially) are within reasonable bounds.
We can ascertain these anticipated results from the expected returns data from Research Affiliates, which utilizes a quantitative (as opposed to qualitative) means of projecting the expected 10-year returns of various asset classes. As of August 31, 2023, Research Affiliates, through their “Asset Allocation Interactive” software, projected the following asset class returns for the next 10 years:
| RESEARCH AFFILIATES’ PROJECTIONS OF AVERAGE ANNUALIZED RETURNS FOR SELECT ASSET CLASSES, AS OF AUGUST 31, 2023, GROSS OF ANY FEES AND COSTS | |||
| ASSET CLASS (as defined by Research Affiliates) | 5% probability of this average annualized return (or a lesser return) | MEDIAN PROJECTED AVERAGE ANNUALIZED RETURN | 5% probability of this average annualized return (or a higher return) |
| U.S. Large Company Growth Stocks | -3.4% | 3.0% | 9.4% |
| U.S. Large Company Stocks | -1.6% | 4.1% | 9.8% |
| U.S. Large Company Value Stocks | 0.7% | 6.5% | 12.3% |
| U.S. Small Company Growth Stocks | -3.6% | 4.4% | 12.4% |
| U.S. Small Company Stocks | -0.7% | 6.9% | 14.4% |
| U.S. Small Company Value Stocks | 0.6% | 8.1% | 15.7% |
| Foreign Developed Markets Growth Stocks | -0.1% | 6.0% | 12.1% |
| Foreign Developed Markets Stocks (All) | -0.3% | 5.4% | 11.1% |
| Foreign Developed Markets Value Stocks | 4.8% | 11.3% | 17.7% |
| Foreign Developed Markets Small Growth Stocks | -0.1% | 6.6% | 13.3% |
| Foreign Developed Markets Small Company Stocks | 3.0% | 9.8% | 16.6% |
| Foreign Developed Markets Small Value Stocks | 5.0% | 11.5% | 17.9% |
| Emerging Markets Stocks | 2.7% | 10.4% | 18.0% |
| U.S. Real Estate Investment Trusts | -0.2% | 6.9% | 14.0% |
| U.S. Treasury Intermediate Term Bonds | 3.5% | 4.8% | 6.1% |
These are estimates, or projections, only, and are NOT a guarantee of any future returns. There is a distinct possibility that the returns of one or more of the asset classes may be significantly lower, or significantly higher, than the range of estimates provided for that asset class, as set forth above. Stock returns can be affected by many factors, including but not limited to changes in valuation levels with ending results significantly above or below the historical average levels, changes in tax policies, changes in interest rates, changes in the rate of inflation, changing investor perceptions and appetites for risk, and many different macroeconomic factors. All of the returns shown are gross nominal expected returns, prior to any deduction for mutual fund / ETF or other fees, expenses, transaction costs within a fund, and the fees of any separate (from the fund) investment adviser. Nominal returns also do not reflect the impact of taxes which may occur, depending upon the type of account in which the investments are held, along with other factors. You cannot invest directly into an asset class; investments must be made by purchasing securities (individual securities, mutual funds, ETFs, etc.).
As seen the chart above, value stocks in the U.S. are expected to outperform growth stocks. There is always the possibility that the major technology companies (Apple, Microsoft, Meta, Alphabet, Nvdia, etc.), whose stock prices all appear to be elevated (in my opinion) at present, will emerge with new or improved products, leading to even greater levels of profitability (and increased share prices). Still, the high valuation levels of many technology stocks today should breed caution for investors. Many a time some group of investors, in the distant past, has stated – “This time it’s different” – only to regret those words some years later.
We might conclude from the chart above that it is extremely unlikely that an investor in a “total stock market fund” in the U.S. is unlikely to achieve the approximate 10% average annualized historical returns of this broad asset class.
I would also urge caution in using the expected returns data above. The projected returns assume reversion to the mean of asset class valuation levels (for the median projection). While starting valuation levels inform us, low valuation levels (as seen in the previous chart of the CAPE10 Ratio and subsequent 20-year returns) do not lead to the inevitable conclusion that future equity returns will be higher. There exists a wide dispersion in potential outcomes.
So, investor – what to do?
- Diversify among several different asset class.
- “Tilt” the portfolios toward “factors” (characteristics that can group stocks of similar traits) together – using only the dozen (or less) factors that possess strong academic support.
- And, to guard against a potential severe drawdown in the valuation levels of stocks, as occurred in 2007-2009, 2000-2002, 1973-1974, and other periods (including twice during the “Great Depression” from 1929 through 1941), possess high-quality bonds for some portion of the portfolio. A good rule of thumb is to determine how much you will withdraw from your portfolio over the next 10 years, and set that amount into high-quality short-term and intermediate bond funds, CDs, or municipal bonds (as your circumstances dictate). For example, if you are retired, and withdrawing 4% a year from your portfolio, then consider placing 20% into short-term, high-quality fixed income investments, and another 20% into intermediate-term high-quality investments (or other investments which possess a very strong probability of positive returns over 6-year periods), with a maximum allocation to equities of 60%. However, this is only a rule of thumb, and you should carefully review your strategic asset allocation decision with your investment adviser.
Is Now the Time to Lock in Higher Bond Yields?
In recent months the yields of intermediate-term and longer-term bonds have increased, relative to the increase seen in short-term bond yields.
Research shows that the best time to “go long” with bonds is when interest rates stop to rise. This makes sense. The problem is, often interest rates fall rapidly, such as in the event of adverse economic news. Hence, timing interest rates – i.e., when to invest at the peak – is very, very difficult.
As of September 30, 2023, per The Wall Street Journal, U.S. Treasury bond yields were as follows:
1-Year 5.373%
2-Year 5.054%
3-Year 4.802%
5-Year 4.616%
7-Year 4.620%
10-Year 4.579%
30-Year 4.703%
These rates are significantly higher than the interest rates generally seen since 2009. For the first time in nearly 15 years, newly acquired fixed income investments can become significant contributors to an investor’s returns.
As seen, the rates for long-term bonds and 1-year bonds have narrowed to about 0.6%, with the yield curve still inverted.
Higher yields, for some maturities, are available from bank-issued certificates of deposit. In addition, extremely high-quality short-term or intermediate term corporate bonds, or high-quality municipal bonds (for certain investors in higher income tax brackets), can make sense.
In addition, all or part of the fixed income portion of the portfolio might be invested in bond mutual funds and ETFs, to provide better liquidity without the worry of the transaction costs of bonds.
A bond ladder is one way to structure part of the fixed income portion of a portfolio. The decision to go with longer maturities in a bond portfolio is highly dependent upon each investor’s risk profile, as well as when and to what extent funds are needed from the investment portfolio. The yield curve can substantially affect how a bond ladder is formed.
Evidence-Based Investing
My firm, Scholar Financial, LLC, embraces evidence-based investing.
There are many investment products that are overly hyped. While the standards governing financial intermediaries has somewhat improved (overall) over the last 20 years, still many product sellers seek to push highly expensive investments.
Expensive investments have been shown to have lower returns than less expensive investments, all other things being equal.
Hedge funds, private equity, venture capital, and other “exotic” investments often possess historical (and future expected) returns far below those of low-cost stock ETF and mutual fund strategies. And they often expose clients to undue amounts of risk.
There actually are just a few investment strategies that “work” in the world of investing, over the very long term. Acting in your best interests, as a fiduciary at all times, involves continual review of investment strategies, as a means of seeking out a higher probability of greater expected returns over the long term. And, in doing so, assisting you to pursue and fulfill your hopes and dreams.
Thank you!
Ron
Dr. Ron A. Rhoades serves as Associate Professor of Finance and Director of the Personal Financial Planning Program within the Gordon Ford College of Business at Western Kentucky University. He teaches and has taught courses in Retirement Planning, Applied Investments, Advanced Investments, Estate Planning, Financial Plan Development, Personal Finance, Money & Banking, Risk Management and Insurance, and Principles of Finance. He is regarded as a national expert in the application of fiduciary duties to the delivery of investment and financial planning advice. Ron’s next book, Mastering the Science and Art of Investing: Strategies for Maximizing Returns with Multi-Factor Portfolios, is anticipated to be published in early 2024.
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