Managing Expectations Down

Vanguard founder John Bogle tells Benzinga that he expects a long-term nominal return on the US stock market of roughly 7.0% a year, based on a current dividend yield of around 2.0 percent plus expected earnings growth of 5.0%. In the years ahead, however, he thinks that the market’s valuation will slide to a price-earnings ratio of 15 from the current 20, which pares the near-term return forecast to around 4.0%. But it gets worse. “When you factor in the costs associated with index funds, inflation, and taxes, you are actually looking at real returns of nominal to zero,” Bogle said.

A recent forecast of real return for the S&P 500 via Research Affiliates also anticipates a weak performance—a real return of just 0.7% annualized for the decade ahead. Analysts will quibble over the exact numbers, but one thing that unites most predictions for equity performance: returns will be well below the stellar 16.8% annualized total return for the S&P 500 for the five years through June 8.

The outlook for investment-grade bonds—Treasuries in particular–isn’t impressive either these days. After a three-decade bull market that’s witnessed yields fall to record lows recently, it’s likely that long-run performance for fixed-income will suffer relative to what we see in the rear-view mirror. For instance, the Barclays Aggregate Bond Index’s annualized total return for the five years through June 8 is 3.5%. But that modest performance will probably look pretty good vs. what the next ten years will bring, based on Research Affiliate’s Mar. 31 forecast of just 0.7% a year.

Performance for bonds may turn out to be higher if yields continue to fall, which implies that economic growth will materially weaken. But that scenario isn’t productive for equities. In any case, if we’re projecting returns beyond the next phase of the business cycle, it’s hard to see how performance for US stocks and bonds will match, much less exceed, the results over the last five years.

Let’s be generous and assume that stocks match Bogle’s long-run nominal projection of 7.0% annualized for the foreseeable future. Meanwhile, we’ll use the current yield of around 2.4% for the benchmark 10-year Treasury Note as a return projection for bonds—a relatively reliable forecast, by the way, since buying and holding a new 10-year Note to maturity is destined to deliver exactly that result. The point is that a stock/bond portfolio based on these projections offers an unexciting forecast relative to the results in recent years.

Ignoring the recent past, however, is going to be tough when it comes to managing expectations. Vanguard’s Balanced Index mutual fund (VBINX), for instance–a portfolio that tracks a conventional 60/40 US stock/bond mix–sets a high standard. The fund’s trailing five-year return through June 9 is a potent 11.6% annualized total return, according to Morningstar. Expecting anything close to that performance for a similar strategy for the next five years requires a hefty dose of heroic assumptions.

If muted expectations for beta are a reasonable bet, that leaves investors to pick up the slack with deft decisions on asset allocation, rebalancing, and/or security selection. Or maybe you’re counting on a new round of speculative frenzy that dispenses unusually high returns?

A reasonable forecast, however, should be humble at this late date. As such, earning a risk premium in a diversified portfolio appears destined to become considerably tougher for the years ahead. But there may be a bright spot buried in the diminished long-run expectations: mean reversion.

The time-varying preferences of investors, aka fluctuating periods of greed and fear, will likely endure. As Ben Graham famous explained, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” That’s a clever way of reminding us that noise will continue to dominate short-term market activity. The crowd, as is its habit, will indulge in periods of going to extremes, in both directions. The net result: short- to medium-term performance will probably deviate substantially at times from the long-run projections–even when those projections call for weak results.

Therein lies what is arguably a robust opportunity for enhancing what’s likely to be a modest return for a passive mix of the major asset classes. But there’s a catch: Most folks won’t be able to tap into the superior returns by this methodology. Why? Let’s just say that behavioral biases will intervene.

All the more reason to focus on developing a rigorous, disciplined rebalancing strategy for a broad spectrum of asset classes that emphasizes the quantitative over the qualitative. Easier said than done, of course. Given the current climate, it’s reasonable to wonder if we’re on the cusp of a new era of unusually disappointing results for the vast majority of portfolios.