What can we expect from the markets?
Photo: H Hatch. Source: Pixabay
When we’re making plans, it’s important to have appropriate expectations, especially when it comes to our finances. Having a long-term outlook is crucial. People put their money to work for lots of reasons: saving for retirement or college, to create a legacy, or to generate income for current expenses. Whatever our goals are, we can prepare better if we have appropriate expectations.
So what can we expect from the markets? Short-term, they will fluctuate. That’s a bit of a cop-out, but it’s true. We don’t know the future, and markets rise and fall for all kinds of reasons. Will North Korea do something reckless with its nuclear arsenal? What will happen in Germany’s Federal elections next week? Will the US Congress enact tax reform – or reduction – this year? No one knows. The news is indeterminate. And, in the short run, the market reacts to the news. If there’s a risk of a trade war, the markets will try to price in this risk.
But, paradoxically, longer term returns can be more predictable. We start with some basic assumptions: the global economy will continue to grow, and our political order won’t radically change. Given that scenario, we know what risk-free bonds will return in the US over the next 10 years: about 2%. That’s what the yield-to-maturity is for 10-year US Treasury Notes. Over time, the yield on US Treasuries has been the best predictor of bond returns – because your return on a bond comes from what the bond pays you. If you buy a fixed-rate bond and hold it to maturity, your return will be the yield.
Corporate bonds and mortgages pay a little more, because they have to. No one would buy a risky corporate bond or a mortgage that can prepay if they can get a risk-free bond that pays the same. So returns on the overall bond market should be 2 ½ to 3 percent. Again, in the short run those returns may be higher or lower due to interest rate fluctuations. But with bonds, what you see is what you get.
Photo: Katerina Tuliao. Source Wikipedia
With stocks, it’s complicated, but over the long run, it comes down to earnings. Stock returns follow the growth in their operating profits. Shareholders have a residual claim on those earnings, whether they get paid out as dividends or reinvested back into the company. And earnings are risky – more risky than bond yields, because they’re lower down in the company’s capital structure. If something goes wrong, bondholders get first dibs on the company’s cash. Stockholders get paid last.
As a result, there’s an equity risk premium that we add to our forecasted bond market returns to come up with expected returns on stocks. To calculate this, we can look at its level over history, our economic outlook, and what stocks are earning now. Over the long run, this number has averaged between 5 and 7%. The US markets’ earnings yield – total earnings divided by market capitalization – is also about 5%. Finally, the US economy has had a 5% nominal growth rate for the past 30 years – although that’s been trending lower. But 5% seems to be a common number. So, I’d suggest using 5% as our risk premium. This gives us an expected 10-year total return on equities of 7 to 8%: 5% from price appreciation, and 2% from dividends. Of course, these are averages. Just as with automobiles, your mileage may vary.
Photo: Choe Kwangmo. Source: Wikipedia
Markets aren’t magic. They provide returns to investors because the underlying companies create economic value – goods and services consumers and other businesses are willing to buy. This economic value generates returns, and we can use those expected returns as a starting point in our financial plans.
Just don’t set your plans in stone. The best laid plans can go astray. As Shakespeare writes, expectations can fail – and often when they promise the most. The markets are where we start. Where we finish depends mostly on us.
Douglas R. Tengdin, CFA