There is a very strong likelihood that returns for investors over the next decade will be significantly lower than what we have seen in the past ten years. With the trailing ten-year return of the S&P 500 at around 10% and the ten-year return of a 50-50 stock and bond portfolio at a little less than 7%, investors have become accustomed to above average returns.
But long-term data indicates that these ultra-strong returns are very unlikely to persist. For stocks, the best predictor of future returns is the starting valuation. Regardless of which metric you use, current valuations are above the 90th percentile, which means future returns are likely to be well below average. Take a look at the chart below from Research Affiliates. Based on current valuations, the expected ten-year returns on US small and large-cap stocks are both below 3%. That is far lower than what we have been accustomed to over the past 10 years.
The outlook for bonds is not any better. The projected total returns on US bonds are also below 3% across the board.
The reality is pretty clear. Whether you invest 100% in US stocks, 100% in US bonds or in a 60/40 portfolio, your returns in the next decade are likely to be low (or at least a lot lower than in the past 10 years). And volatility is likely to rise from the historically low levels we have seen, so the ride to get to those low returns is probably not going to be a smooth one.
What are investors’ options in this low return environment?
Perhaps the most important thing is to recognize the situation and adjust expectations accordingly. The most dangerous response investors can make to projected low returns is to begin taking more risk in search of higher returns. That approach is unlikely to produce those high returns and would increase risk. Taking a level of risk that is beyond what is appropriate for you is a recipe for disaster.
The other important fact to recognize is that lower expected returns over the next decade say nothing about what returns will be this year or next year. Over the short-term, markets are completely unpredictable. Although starting valuations can tell you a lot about future returns in the next decade, they tell you nothing about returns in the next year.
With those two caveats, I do think there are some areas that could help to supplement a standard US stock and bond portfolio and potentially increase future returns relative to the standard 60/40 portfolio.
Below are some ideas.
U.S. investors tend to exhibit home country bias. We tend to have too much of our portfolios in U.S. stocks and bonds. international assets can not only help increase returns over time, but they can also act as diversifiers during periods where U.S. assets are not doing well.
Over the last 10 years, U.S. stocks have substantially outperformed international stocks, as you can see from the chart below (the S&P 500 is up 137% and international stocks are up about 1%). As a result, international stocks offer a major advantage relative to U.S. stocks at the current time – they are much cheaper. And cheaper valuations lead to greater long-term expected returns. If you look at the Research Affiliates chart above, you will see that expected returns for international stocks are significantly higher than U.S. stocks across the board. The projected returns for developed international stocks are above 6% annually and the projected returns for emerging market stocks are almost 8%.
International bonds can also add diversification benefits. For example, when the U.S. dollar is depreciating relative to other currencies, as it did last year, international bonds get the added return of currency appreciation in addition to their standard returns.
The long-term evidence is very strong that diversification beyond your home country improves risk-adjusted returns. With valuations significantly cheaper overseas, now could be a good time to consider adding some exposure.
Consider Value Stocks
Any analysis of the U.S. stock market as a whole tends to have one major weakness – it treats the market as if all stocks are the same. The reality, though, is that underneath those overall market valuations are very different segments of the market that perform very differently. As an example, consider the late 90s tech boom. During that period, the market reached the highest valuations it ever has, and stocks became very expensive. But value stocks did not participate in that run-up and were not expensive, even at the peak. As a result, value stocks did far better than the market during the subsequent low return decade, and adding exposure to them when valuations were extreme helped to enhance long-term returns.
We are not in such an extreme situation now, both in terms of market valuations or the difference between value and growth multiples. But we are currently in the midst of one of the longest periods of value stock underperformance in history, and value stocks look very cheap relative to growth stocks. I wrote a full article on this a month or so ago so I won’t get into all the details here, but if history is any guide, value stocks could be an excellent place to be for the low return environment we are likely to have going forward.
Take a Look at Commodities
While stocks have produced well above average returns since 2008, commodities have been heading in the opposite direction. The chart below of the performance of the PowerShares DB Commodity Tracking ETF (DBC) shows just how bad the performance has been.
With extended negative performance comes opportunity, though, and now could be a good time to consider some exposure to commodities for a couple of reasons. First, the history of commodity prices has been characterized by long periods of both good and bad performance, and this extended period of bad performance could provide an opportunity in that context. Second, some signs of potential future inflation are beginning to show and commodities have historically performed very well in those type of environments (see the chart below showing commodity performance in high and low inflationary environments).
This isn’t to say that commodities are likely to produce huge returns going forward. They are only likely to keep up with inflation long-term. The Research Affiliates system projects returns over the next decade of slightly more than stocks, and they offer significant diversification benefit as well. So now could be a good time to give commodities a look.
Add in Trend Following
As a buy and hold investor, I was very skeptical of trend following for a long time. What is more important than anything else to me in the long run, though, is evidence. And the evidence to support trend following is very compelling. At its core, trend following is very simple. It provides a mechanism to reduce risk by either raising cash or hedging a portfolio when the trend for a particular asset class becomes negative. When a positive trend is re-established, you reinvest or remove the hedge. Over time, trend following typically reduces both volatility and drawdowns for asset classes. That is important because volatility and drawdowns are what lead investors to make poor decisions and abandon an investment plan at exactly the wrong time. To the extent trend following can help to limit that, it can be a good addition to a portfolio.
Below is the performance of trend following relative to buy and hold for the S&P 500 since the early 1970s using our trend following tool on Validea. As you can see, it has worked very well.
Trend following is not a perfect solution, though. It tends to limit losses during bear market periods, but the tradeoff is that during markets that are oscillating back and forth, it tends to get flipped back and forth and produces a series of incorrect signals that have you buying and selling at the wrong times. Those are offset over the long run by the correct signals during major drawdowns, but they require a significant amount of faith in the system to stay the course during them. Trend following is also not as tax efficient as buy and hold, so it doesn’t work as well in taxable accounts. For more on trend following, you can take a look at my previous article on the topic.
The Reality of Low Returns
Lower future returns are a reality that all of us have to accept. But lower overall returns don’t mean there aren’t pockets of opportunity beneath the surface. At the current time, international assets, value stocks, commodities, and trend following may provide an opportunity to enhance returns and add diversification going forward. Investors may be wise to consider some exposure to them as part of their portfolios.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.