- When the equity risk premium is above average, long-run stock returns will probably beat Treasuries by healthy margins;
- When the equity risk premium is below average, additional long-term returns on stock compared to Treasuries will probably be below average, and may be negative.
Your Portfolio: Maintaining Perspective
by John Markese
You already know the bad news: U.S. stocks as measured by the S&P 500 lost almost 50% from the October 2007 peak though November 18, 2008. Most foreign stock indexes were off by a little more than 50% this year.
The good news is that based on todays depressed prices, long-term stock prospects appear above average.
In this article, we take a look at some of the evidence that supports a rosy multi-year stock outlook, and provide a framework for applying these forecasts.
Without a crystal ball, can investors get a rough forecast of long-term stock returns?
In theory, at least, the answer is yes.
The theory behind long-term stock predictability is relatively simple. It says that the stock markets equity risk premiumthe additional expected return investors demand before they are willing to assume the additional risk of investing in stocks compared to Treasury securitiesvaries through time:
For example, one common model used to put a value on the market is the dividend discount model. The simplest version of this model assumes all earnings will be paid out as dividends, and growth in dividends and earnings will be zero. The model implies that the markets dividend yield (year-ahead dividends divided by todays price) would equal the risk-free rate (as measured by a Treasury yield) plus the equity risk premium investors require for investing in stocks; and because earnings are assumed to be paid out in dividends, it implies that the beginning earnings yield (year-ahead forecasted earnings divided by todays price) would equal the risk-free rate plus the equity risk premium. In shortit implies the markets dividend yield and earnings yield vary directly with long-term stock returns: When the equity risk premium is high, everything else the same, todays earnings yield and dividend yield should be high; when the equity risk premium is low, todays earnings yield and dividend yield will tend to be low.
Of course, the key in this model is the equity risk premium, and unfortunately, investors cannot directly observe the equity risk premium. However, investors can observe the markets earnings yield and dividend yield. And, as the model suggests, they will tend to be high when the equity risk premium is high, and vice versa.
Soin theory at leastthe beginning level of the earnings yield (which is simply the inverse of the markets forward price-earnings ratio) and dividend yield should have some ability to project the additional returns on stocks compared to Treasury securities. Furthermore, any variable that varies with the unobservable equity risk premium should have some ability to project returns above Treasuries.
There is some historical evidence that implies long-term stock returns can be gleaned based on the beginning levels of the earnings yield (or its inverse, the price-earnings ratio) and the dividend yield. Furthermore, studies indicate that other variables appear to have some predictive ability, including the Baa-Aaa yield spread and forecasts based on Value Line predictions.
Table 1 summarizes these relationships.
To put it simply, studies indicate that good long-term stock prospects should be associated with the following:
High beginning levels of earnings yield or low beginning levels of price-earnings ratios;
Wide beginning levels of Baa-Aaa credit spread, where Baa is the yield on triple-B bonds (the lowest level of investment-grade bonds), and Aaa is the yield on the highest-rated triple-A corporate bonds;
High beginning levels of Value Line equity risk premium, which is an estimate of the equity risk premium based on Value Line Investment Survey predictions.
(Although theory suggests that the beginning level of the markets dividend yield should be positively related to future stock returns, we did not include this predictive variable in this article due to reasons discussed in the accompanying sidebar.)
|Dividend Yields and Market Returns|
Historically, the markets dividend yield has also shown an ability to partially predict long-term stock returns. However, in our opinion, the dividend yield may be a less reliable predictor of future returns because other factors may influence the dividend yield, and we therefore did not focus on it in this article.
For example, for the past two decades, the average U.S. firm has reduced its dividend payout ratiothat is, the percentage of earnings paid out as dividends. Many firms subscribe to the theory that many investors do not want cash dividends with their associated tax bills, and instead would prefer to see the dividends reduced and the earnings reinvested in the firm or used to fund share repurchases. The lowering several years ago of the maximum federal tax rate on qualified dividends to 15% may have reversed the long-term trend toward lower payouts.
Despite its limitation, todays (November 20, 2008) S&P 500 dividend yield is at its highest level since 1991another suggestion that long-term stock prospects are above average.
|Table 1. Predictors of Long-Term Stock Returns|
|Predictive Variable||Long-Term Stock Returns|
|High E/P ratio (earnings yield)||Good Prospects|
|Low P/E ratio (price-earnings ratio)||Good Prospects|
|Wide Baa-Aaa spread||Good Prospects|
|High Value Line equity risk premium*||Good Prospects|
|*An estimate of the stock markets equity risk premium based on predictions from Value Line Investment Survey.|
For this article, we examined three specific measures that have shown promise in terms of projecting where long-term stock returns may head relative to Treasuries. Keep in mind, however, that the research shows only a limited ability of these measures to predict long-term returns.
First, we took a look at Shillers P/E (price-earnings ratio). Robert Shiller is a leading scholar who wrote Irrational Exuberance, a book on the New York Times Bestsellers list that was first published in January 2000 (Princeton University Press). It argued that the stock market was in an unsustainable bubble. The stock market peaked in March 2000. In the second edition, which was published in 2005, Shiller concluded that there was a bubble in the U.S. residential real estate market. In short, his predictions have been remarkably accurate. The numerator of his P/E model is the current real (or inflation-adjusted) level of the S&P 500; the denominator is the average real earnings for the past 10 years. The use of a 10-year average for earnings is designed to better reflect movements in the markets normal earnings, where normal earnings are the level of earnings that excludes the impact of the business cycle.
Figure 1 graphs the beginning level of the earnings yield, that is, the inverse of Shillers P/E, and 10-year ahead real returns on the S&P 500 for the 1880s through today. The return scale shows the cumulative 10-year real return, so 2 denotes a 200% 10-year cumulative real return. In theory, the earnings yield should move directly with future long-term returns. Figure 1 confirms this expectation. In general, low levels of earnings yield (high levels of Shillers P/E) are associated with low future real returns and vice versa.
This forecasting model is not perfect; market risk still remains. However, there has been a persistent strong positive correlation between the beginning level of earnings yield and subsequent 10-year real returns.
Shillers P/E has averaged 16.3 since 1881 and 19.3 for the past 50 years. In December 1999, Shillers P/E was 44.2, a record high, so his model predicted poor real returns for 20002009. Although this 10-year horizon is not over, subsequent returns have been disappointing.
Shillers Web site and Figure 1 only includes data through August 2008, when Shillers P/E was 20.67, which corresponds to an earnings yield of 0.048. In the December 8 edition of the Wall Street Journal, Shiller said his P/E was at 13.4 in November, which corresponds to an earnings yield of 0.075. This is the lowest P/E in 21 years, and the first time it has fallen below 14 since 1988.
The Baa-Aaa Spread
Another well-respected research study (by Profs. Eugene Fama and Kenneth R. French) concerns the yield spread between Baa and Aaa bonds. Historically, Fama and French conclude that the Baa-Aaa credit spread has shown some ability to predict long-horizon stock returns. The logic is that this spread moves with the unobservable equity risk premium. Therefore, when the Baa-Aaa spread is large, the unobservable equity risk premium tends to be large, and future long-term stock returns are usually generousand vice versa.
Using monthly averaged yields since 1968, Figure 2 graphs this spread and the subsequent five-year cumulative real S&P 500 returns.
Figure 2 suggests, at least to us and some researchers, that the Baa-Aaa spread has some ability to predict long-term returns. When the spread has been low, subsequent five-year returns have tended to be low, and vice versa. The spread was usually less than 1% when subsequent five-year real returns were negative. When the spread exceeded 2% in much of 1980 through 1982, subsequent real returns were strong. However, this spread failed to predict the dramatic bull market of the late 1990s and subsequent crash. We attribute this failure, at least in part, to the irrational pricing at that time; that is, the model is based on the idea of rational valuation, but the level of the stock market was not rational in the late 1990s. Nevertheless, it reinforces the limits of any model.
The November 2008 spread was 3.07%, which is its highest level since 1933. It suggests well-above-average returns.
The Value Line Predictor
The last predictive variable we call the Value Line predictor. Each week, Value Line Investment Survey presents the median projected year-ahead dividend yield and median three- to five-year price appreciation potential for the approximately 1,700 stocks in its main sample. Interpreting the projected median price three to five years hence as the price in four years, we estimate an average annual capital gain. Adding the Value Line dividend yield to this Value Line capital gain gives us the projected total return. Subtracting a Treasury bill yield produces an estimate of the markets equity risk premiumwhat we call the Value Line equity risk premium. Prior studies by one of these authors (Reichenstein, along with Prof. Rich in 1993) concluded that the Value Line equity risk premium has some ability to predict excess returns on the S&P 500 for the six-quarter-ahead forecast horizon.
Figure 3 graphs the actual and projected excess returns where excess returns are the additional returns on the S&P 500 above Treasury bills.
The six-quarter-ahead forecast horizon is much shorter than the 10-year horizon for Shillers P/E and the five-year horizon for the Baa-Aaa spread. Therefore, it should not be surprising that the model is far from perfect. For example, it failed to predict the 19731974 bear market associated with the Arab oil embargo, but it predicted the market rebound in 1975. It estimated returns that were too low when the stock bubble was forming in the late 1990s and estimated returns that were too high during the subsequent bursting of the bubble in 20002002. Furthermore, the Value Line equity risk premium may have an optimistic bias, since its predicted returns usually exceed future returns. This should not be surprising since financial analysts (in this case, those at Value Line) tend to be optimistic.
Nevertheless, Figure 3 suggests that the Value Line equity risk premium measure has some ability to forecast returns.
When reading the graph, the last observation for actual S&P 500 excess returns is for March 2007, and it denotes the actual excess return of 20.4% from April 2007 through September 2008; at that time, the Value Line equity risk premium was 16.12%.
As of November 21, the Value Line equity risk premium indicator suggested that stocks would beat Treasury bills by almost 30% per year for the next 18 months.
What Actions Do They Imply?
What do these rosy stock prospects mean for investors? This section discusses some of the implications. First, it begins by discussing how the average investor manages his money. Then, we discuss two better strategies.
The average investor buys stocks at or near the end of a bull market and sells at or near the end of a bear markets. He buys high and sells low. This was shown in one study that examined the timing ability of equity fund investors. For 19912004, the average investor lost 1.56% per year compared to a buy-and-hold strategy. On average, investors buy stocks after bull markets such as in 1999 and sell stocks after bear markets such as today.
We suspect that many investors let emotions rule the day, which causes them to follow this buy-high-and-sell-low strategy. It is tough to be objective, especially in bear markets.
A fixed-weight strategy is one good strategy. With this strategy, an investor selects his or her strategic asset allocationthat is, the long-run normal asset allocation. For example, suppose an individual selects a 60% stocks and 40% bond strategic asset allocation. Periodically, perhaps once a year, he rebalances his portfolio back to this 60%/40% strategic mix.
By its nature, this fixed-weight strategy is contrarian. After a good year, the investor must sell stocks and buy bonds. After a bad year, the investor must sell bonds and buy stocks. From our experience, most investors find it more difficult to buy stocks after a bad year than to sell stocks after a good year. One advantage of the fixed-weight strategy is it helps the investor overcome inertia. No one knows whether the recent market trend will continue. So, it is never clear whether we should reduce stock exposure after a good year or increase stock exposure after a bad year.
In the absence of clarity, many investors do nothing. The fixed-weight strategy requires the discipline to rebalancethat is, to overcome inertia.
Tactical Asset Allocation
Tactical asset allocation is a variant of a fixed-weight strategy. It says investors should periodically rebalance their portfolios. But, instead of always rebalancing back to their strategic asset allocation, they should rebalance back to an asset allocation that may vary slightly from the strategic asset allocation. For example, someone with a strategic asset allocation of 60% stocks and 40% bonds may allow their target stock allocation to vary from 50% to 70% based on long-run market prospects.
In practice, tactical asset allocation is more contrarian than strategic asset allocation. After a period of strong performance, tactical asset allocation may require this investor to not only reduce his stock exposure but also to reduce it below the 60% strategic weight. After a period of poor performance, tactical asset allocation may require this investor to not only increase his stock exposure but also to increase it above the 60% strategic weight.
Tactical asset allocation is not an easy strategy to follow. In the second week of October, one of the authors rebalanced his portfolio back to his strategic weights. The next week, he increased his stock exposure to 5% above his strategic weight. The latter was not easy. His objective side looked at the objective evidence of long-horizon stock prospects discussed above and concluded that the higher stock exposure was warranted. But his emotional side looked at the dramatic losses incurred in the prior weeks and year and wanted to head for the exit or, at least, await further evidence.
Tactical asset allocation may not be easy to follow after a period of good returns. At the end of 1997 after three straight years of over 23% returns on the S&P 500, Shillers P/E was above average at 33.0, which suggested below-average stock prospects. Suppose an investor reduced her stock exposure at that time. In 1998, the S&P 500 had another stellar year clocking returns of 28.6%. At the end of 1998, this price-earnings ratio was 38.8, which suggested even worse long-horizon prospects. So, she further reduced her stock exposure. In 1999, the S&P 500 earned 21%, some of which our intrepid investor lost due to her tactical bets. Based on the markets price-earnings ratio and the other predictive factors, long-horizon stock prospects looked even worse. What should she do?
After the fact, the answer is clearshe should stick to the tactical strategy and sell stocks until her stock allocation is below her strategic stock allocation. Although the answer is clear, after the fact, we know of investors that lost faith and either failed to reduce their stock exposure at all or only sold enough stocks to reduce their stock allocation to their strategic allocationright before the stock bubble burst.
What NOT to Do Now
We emphasize two things that investors should not do now. First, do not bail out of the stock market now. Recall that the average investor buys when prices are high and sells when prices are low. We can all agree that that is a lousy way to manage money.
Suppose your strategic asset allocation is 60% stocks and 40% bonds. If stocks lose 33% and fixed-income assets are flat then your new asset allocation is 50%/50%. The market has already reduced your stock exposure.
Bailing out of the stock market would be an example of market timing. Successful market timing requires two good decisions: when to exit the market and when to reenter. There is scant evidence that anyone can consistently make one successful call, much less two.
Second, do not stop investing, and consider increasing your savings. Conversations with investment professionals suggest that many individuals are reducing or ceasing contributions to their tax-advantaged retirement planse.g., 401(k)s and Roth 401(k)s. A professor told one of us that she was stopping contributions because the market was losing her money faster than she could contribute to it. This strategy only makes sense if she does not plan to eat in retirement.
The reality is that her nest egg has shrunk, but her retirement plans probably have not changed. No one can control market returns, but she can control the amount she saves each year and her asset allocation. She should face reality and accept her responsibility to save for her retirement. Because of the bear market, she probably needs to increase the amount she savesor reduce her retirement expectations.
What You SHOULD Do
We provide separate advice for individuals still working and for those who have retired from the workforce.
If you are still working, we recommend that you rebalance your portfolio back to your strategic asset allocation. If you never rebalance, you are guaranteed to have the lowest stock allocation when the market hits its bottom. That does not make sense.
Second, you might consider a slight tactical betthat is, raising your stock allocation perhaps 5% to 10% above your strategic allocation. Remember, the evidence suggests higher long-term returns. It does not guarantee higher long-term returns, and the research is silent on stock prospects for horizons of one year or less.
Third, if circumstances warrant, consider increasing the amount you save each year. The most tax-advantaged savings vehicles continue to be tax-deferred accounts like the 401(k), SEP-IRA, and traditional IRA and tax-exempt accounts like the Roth IRA and Roth 401(k). So, save all you can afford to save in these most tax-favored savings accounts.
If you have retired from the workforce, then you no longer have the option to save more. We do, however, recommend that you rebalance your asset allocation back to your strategic asset allocation.
Recent retirees may consider a slight tactical tilt. Recent retirees have a longer life expectancy than they may think. A 65-year-old female has a life expectancy of about 20 years and at least one partner of a 65-year-old couple will probably live 24 years or more. For longer horizons, stocks usually beat bonds. As discussed in my article Will Your Savings Last? What the Withdrawal Rate Studies Show, (July 2008 AAII Journal; available at AAII.com) the withdrawal rate literature suggests that, to minimize the longevity risk (the risk of running out of money in their lifetimes), retirees should have at least 50% stock exposures. Although we are not necessarily advocating that large a stock exposure for all recent retirees, a healthy dose of stocks appears necessary to minimize longevity risk.
We encourage older retirees to rebalance back to their strategic asset allocation. That allocation may contain a relatively small stock exposure. But they should want some stock exposure since an all-bond portfolio is not the lowest risk portfolio. And it usually pays to rebalance when stocks are low. Retirees with small nest eggs for their life expectancies and limited risk tolerances would probably not want to consider a tactical bet. But some retirees have larger nest eggs than they will likely need. Part of their nest eggs may be savings that are intended for their children. They may wish to not only increase their stock allocations back to their strategic targets, but to further increase their stock allocations by taking slight tactical bets.
No one needs to tell investors that stock returns have been lousy over the last year. Indeed, stock returns have been lousy for this decade.
The good news is that long-term stock prospects appear relatively generous from here.
Todays market price-earnings ratios, the Baa-Aaa credit spread, and Value Line Investment Survey forecasts all suggest that todays long-horizon stock prospects appear above average.
None of these variables singly or in combination can guarantee strong long-term returns. But they do suggest above-average prospects. Furthermore, these variables predictive ability is based on the theory that they should signal an above-average equity risk premium. Based on the fear in todays market, it seems reasonable to conclude that todays equity risk premium is high. We encourage investors to rebalance their portfolios back to their strategic asset allocations. If your normal asset allocation is 60% stock and 40% bonds then you should rebalance back to this strategic mix. This means selling bonds and buying stocks. If you have the willingness and ability to bear additional risk, then you might consider an even more contrarian strategy by rebalancing back to a stock exposure that is perhaps 5% to 10% above the strategic stock weight.
We encourage investors not to bail out of the stock market. Historically, the average investor sells at or near market lows and buys at or near market highs. Such moves often occur when individuals let their emotions rule the day. Furthermore, individuals who are still working might consider increasing the amount they save each year. The poor returns of the past year and this decade may mean that they will have to increase their savings to meet their retirement goals.
Additional Reading: References for studies discussed here appear at the end of the on-line version of this article at AAII.com.