Following yesterday's post on the long-term compounding potential of SMI's strategies, today we're going to look at what the fundamentals say about the future return potential for various asset classes. While asset prices can move somewhat independently of their underlying driver in the short-term, in the long run the health and growth rate of the underlying company/economy/etc. matters greatly. For example, U.S. stock prices can and do soar and plummet at times independent of any close tie to the health of the U.S. economy. But in the long run, those stock returns are limited to a significant degree by the ability of businesses to grow profits.
Not surprisingly, there are plenty of relatively negative projections out there for the future rate of growth of the U.S. (and global) economy, making pessimistic projections about investment returns fairly popular. Forbes recently provided a fairly detailed breakdown of what future returns should be expected from several different asset classes. While I don't agree with all of it (and would caution that any such analysis be taken with a grain of salt), on balance it seems pretty reasonable.
Stocks always get the most attention, but I want to touch on them only briefly before moving on to the class that really grabbed my attention. Yesterday's blog post used the 8.28% annualized return of U.S. stocks over the past 10 years as its jumping off point. Forbes uses "real" returns in its analysis, meaning inflation is taken out. Given that inflation has run about 2% in recent years (and that is the Fed's stated inflation target), that would reduce the 8.28% return we started with yesterday down to a 6.28% "real" return.
The author goes on to make the case why a 5% real return for stocks is more realistic. I was actually a little surprised they anticipated it would be that high, based on some other analysis I've seen elsewhere. Yes, one of the main points of yesterday's post was to illustrate how valuable every extra 1% of return is, so it's not as if the difference between 6.28% and 5% doesn't matter. But if they're only projecting a drop of 1.28% from what we used as yesterday's starting point, SMI investors will still be sitting pretty, assuming the relative relationships between the market's returns and SMI's strategy returns remain relatively constant.
The real eye-opener for me wasn't their stock projection, it was their junk bond projection. We haven't talked much about junk bonds in recent years, so I don't know if there are many SMI readers who own them. But if you do, you'll definitely want to read the full Forbes analysis for that asset class.
In the intro of the article, the author says this about junk bonds, and really more to the point, about the terrible timing skills of investors as a group:
In tumultuous 2008, when junk bond prices were depressed, their yields averaged a 10% premium over safe Treasury paper. That was a good time to be buying. But retail investors were doing more selling than buying. That year junk funds saw $6 billion of net redemptions, not counting reinvestment of dividends, according to data from the Investment Company Institute.
Six years later the prices of risky bonds have recovered, and their yields are correspondingly lower. What are investors doing? They should be selling, but they are not. In 2013, when the yield premium on average was only half that of 2008, investors poured a net $54 billion into junk funds. The money is still coming in ($10 billion in the first four months of this year).
Here's a brief summary of Forbes' analysis of the future for junk bond returns. They start with the current SEC yield for the category of 4%. This takes into account "the price erosion of bonds that are trading at a premium and are destined to sink back toward par as they mature."
From that 4%, Forbes says we need to subtract about 1.3% for defaults (read the whole thing for the explanation why). That brings us down to 2.7%. After subtracting the same 2% for inflation we discussed earlier, they project the total return to be maybe 0.7% per year going forward. They then give some pretty compelling reasons why even that seems too optimistic and why outright losses seem likely.
Bottom line: risky bonds, with plenty of downside, and upside of around zero. Sound like a winner?
Unfortunately, it's not like there are lots of other great options for bond money. They note that a current 10-year Treasury bond currently yields 2.6%, which is a meager 0.6% per year after inflation. And that assumes you buy and hold it for 10 years so rising interest rates aren't a factor.
Still, while we might not always like what the fundamentals say, it's good to be aware of roughly where they stand. Again, the markets can defy the fundamentals for a while — sometimes quite a long while. But eventually they do matter. They're the reason asset class returns "revert to the mean" or return toward their long-term averages.
Ultimately when you buy an investment, you're buying something real. It might be a share of the future earnings of a business (stock), a promise to be paid interest at a certain rate (bond), or something else. If the value you pay gets too far away from the long-term value of the thing you're actually paying for, that's a problem.