Capital Market Forecasts
In chapter 10 of this book, I describe how to establish expected returns for stocks and bonds, because these returns are so critical to the achievement of financial security in retirement.
The long-term expected return for notes is simply the current interest rate on 10-year US government notes (page 146). If you hold a 10-year note for the full 10-year term of the note, you will get back the money you invested in the note plus the interest rate on the note when you buy it. The yield on the 10-year note was about 4.5% at the time the book was written.
Please note that I have decided to use the historical returns for 10-year notes, rather than those for 30-year bonds, as shown in the book. Historical returns for the 10-year notes have been lower than those for the 30-year bond. I made the change because the 10-year notes are much more representative of the long-term focus of investors in fixed income investments in the marketplace today and in the future than the 30-year bonds.
The long-term expected return for stocks is equal to the current dividend yield plus expected real economic growth plus expected inflation (page 147). In the book, these components were 2%+3%+3%, respectively, for a total of 8%. As noted in the book, this forecast rate of return for stocks was below the long-term rate of return, suggesting that the outlook for stocks was below-average.
These forecast returns for notes and stocks are long-term, meaning at least ten years. How did the forecasts work out over the ten years since the forecasts were actually made in the book, which is the only period which can be evaluated? These data should begin to set the base for your understanding about how reliable forecasts determined as described above can be.
Forecast Returns (%) Actual Returns (%)
Stocks 8.0 Stocks 6.9
Bonds 5.0 Notes 4.6
This is only a sample of one 10-year period, and no reliable conclusions should be attempted from a sample size this small. However, in this case, the returns are close to the forecast returns, and there are two things which can be noted: (1) the return for the 10-year note is what it should be, based on the interest rate at the time, despite the change from the 30-year bond to the 10-year note described above, and the 10-year maturity for the note, and (2) the return for stocks reflects the below-average return which was forecast at the time.
Latest Forecast (5/31/19)
It is very important to determine what the forecasts for the returns for the 10-year note and for stocks are at this point, using the same methodology which was outlined in the book to make the original forecasts.
The interest rate on the 10-year note today is about 2.20%. This, therefore, is the expected return for the 10-year note over ten years.
The three components of expected return for stocks are: current dividend yield, real economic growth rate, and the inflation rate. The current dividend yield is about 2%. Although there is much debate about what the real economic growth rate is, given the change in administrations, the consensus at the moment is that it is about 2%. if the Trump administration is successful in implementing some of its plans, the real economic growth could be higher. Finally, the consensus forecast for inflation is about 2%. This too could be on the low side if economic growth picks up. Therefore, the conservatively estimated expected return for stocks is equal to 2%+2%+2%, or 6%.
Therefore, as we attempt to forecast returns for the next ten years, we find that the interest rate on the 10-year note is very low and half of what it was ten years ago, and the forecast return for stocks is 2% lower than it was ten years ago and only about 2/3 of what it has been historically.
These return forecasts are significantly below normal, and they have a dramatic impact on expected returns from your portfolio over the next ten years. The expected return for a portfolio which is, for example, 50% invested in the 10-year note and 50% invested in stocks has an expected return of only 4%, based on these forecasts. After taxes, this expected return is only slightly better than the expected inflation rate.
If inflation and real growth are higher than currently expected, as is possible as indicated above, then the expected return for stocks could be as high as 8%, and the expected return for a portfolio invested 50/50 in notes and stocks would have an expected return of 5%. Under the best of circumstances, this is still not an impressive return.
The bottom line is that the expected returns for stocks and notes at this point are unusually low. This situation has sobering implications for all investors, from individuals, who are trying to accumulate funds for retirement, to state and local governments, whose pension plans are typically already very poorly funded.
The only way for the expected returns for notes and stocks to go up significantly is for both assets to decline significantly in price, and such declines will only make things worse. In other words, what the expected returns for both notes and stocks suggest is that both assets are overvalued.
What are the implications of the poor outlook for returns from 10-year notes and from stocks? I would offer three observations:
- As always, Jack Bogle, the founder of Vanguard, says "Stay the Course", even with the outlook for low returns . Most investors are not capable of successfully moving into cash at the right time and moving back into long-term investments at the right time. They will shoot themselves in the foot, or worse. Bogle's advice is very sound.
- Don't have high expectations for returns at this point, don't be surprised if there are declines in the markets, and be ready to add to your portfolio if they materialize.
- Remember that if you are contributing to your investment program on a monthly basis through, for example, a 401(k) plan, you will have the opportunity to make regular additions to this program as and if markets decline at what could be favorable prices.
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