Time to Reset Expectations

People resetting expectations

We are now in the eighth year of an equity bull market, making this the second-longest upswing in American history.¹ Additionally, the bond market has been in a secular bull market since 1982 as rates on the 10-year treasury fell steadily from above 14 percent to below 2 percent last year.² The recent strong returns we have experienced may be difficult to sustain due to equity valuations, near-record corporate profit margins, and low interest rates. This is not to say we are in a bubble or an imminent bear market looms, however now is a good time to reset long-term investment return expectations for participants. In fact, California’s state public pension system, Calpers, recently lowered their expectations for long-term investment returns from 7.5 percent to 7 percent.³ Even those reduced projections may prove optimistic.

Equity returns are primarily a function of three factors: earnings growth, the multiple paid for earnings, and dividends. Earnings have benefitted from near-record corporate profit margins.⁴ Since the Great Recession, corporate profit margins have expanded on the back of cost cutting, low labor costs and low interest rates. This margin expansion has fueled earnings growth and any reversion to the mean would create a headwind for earnings going forward.⁵ Furthermore, the current price-to-earnings ratio⁶ for the S&P 500 is about 18 times forward earnings. That compares to a historical 25-year average of about 16 times earnings.7 These valuation levels are not extreme yet provide less opportunity for future multiple expansion to drive returns. Lastly, the current dividend yield on the S&P 500 is less than 2 percent compared to a historical median yield of over 4 percent.8 For all of the above reasons, U.S. equity returns in the high single digits are unlikely over the coming years from this starting point.

Expect returns from fixed-income investments to also be challenged going forward. The most significant component of fixed income returns are yields. During this secular bull market in bonds, returns have been bolstered by falling interest rates. The current yield on 10-year treasuries is about 2.5 percent. That compares to an average historical nominal yield of over 6 percent.9 Additionally, if or when rates eventually rise, bond prices will be pressured since bond prices move inversely to interest rates. Clearly with yields near historically low levels, expect fixed income investments to return less than they have historically.

This is by no means a signal to exit the market and go to cash. Market timing is a fool’s game because it is impossible to properly time an exit and entry back into the market. As history has repeatedly shown, investors who try to time the market are destined for inferior returns over time. However from the current starting point, it is difficult to envision a balanced portfolio achieving high single digit returns over the next five to 10 years. A low to mid-single-digit return is a more realistic expectation.

  1. http://money.cnn.com/2016/04/29/investing/stocks-2nd-longest-bull-market-ever/
  2. http://www.cfapubs.org/doi/pdf/10.2469/cp.v27.n2.6
  3. Calpers Cuts Investment Targets, Increasing Strain on Municipalities. The New York Times. December 21, 2016.
  4. A “Generational” Peak In Corporate Profit Margins. ZeroHedge.com. April 2, 2016.
  5. A “Generational” Peak In Corporate Profit Margins. ZeroHedge.com. April 2, 2016.
  6. The ratio for valuing a company that measures its current share price relative to its per-share earnings.
  7. 2Q 2017 Guide to the Markets. J.P. Morgan.
  8. S&P 500 Dividend Yield.
  9. 2017 Guide to Retirement. J.P. Morgan.

ACR#244910 06/17