Expected Returns for Stocks

A friend recently forwarded me the address of a fascinating investment website that I have spent hours studying. The site, found here, beautifully displays market forecasts for stocks, bonds, commodities and currencies from around the world.

This site is run by Research Affiliates, an investment research firm that develops indexes and strategies that other investment managers license. They say that as of the end of the third quarter last year, about $177 billion was managed using their strategies.

We actually don’t use any of their strategies, but their founder and chief spokesman, Rob Arnott, is a force in our industry. While he has published more than 100 scholarly articles and served as the editor of one of the more prestigious journals, he also has tremendous marketing savvy.

He is famous for coining the term ‘fundamental indexing,’ which is another way to create a value-oriented portfolio and, more recently, has promoted (if not created, I’m not sure) the term ‘smart beta’ to describe commonly known risk factors.

While the terms fundamental indexing and smart beta might not be part of your everyday lexicon, the terms have dominated our industry for a decade.

Their website has many interesting components, but the link that I provided above (and what held me hostage for so long) was their forecasts for market returns in the coming decade.

I should note that they are very bearish on US stocks, expecting them to earn less than a half of one percent per year over the next decade after inflation, and very bullish on emerging market stocks and currencies.

At this point, I hope you know that I put a low value on actual forecasts, so the output here doesn’t really do anything for me. That’s a little odd, because I really do love the site.

What I find fascinating is the methodology that they’ve created. It’s well grounded in classical financial theory and is well supported by a wealth of data (their transparency is admirable). Plus, it’s beautiful and easy to navigate.

All of those positives aside, I think that the idea that US stocks will do nothing over the next decade after inflation is highly unlikely. Possible? Yes. A base case investment outlook? I don’t think so.

They would say that I’m too fixated on historic returns and there is some truth to that. I agree with Arnott that the returns that the US has experienced over the last century are not likely going to be repeated. We went from an emerging market that just went through a horrible civil war to the world’s single superpower.

Over the last 100 years, US stocks enjoyed six percent per year returns, on average, after inflation. The rest of the world earned around five percent. Over the next 100 years, our starting point is as a mature, developed country, not a scrappy upstart, so I would say that five percent is a best case scenario.

I also agree with Arnott that stocks right now are richly priced. That’s been true for several years – these valuations don’t say anything about the short term, but when valuations are higher than average, it’s reasonable to expect that returns will be lower than average in the future – and vice versa.

If I were to guess, and I am consciously using the word guess rather than predict, forecast or even estimate, that US stocks will earn four percent per year, on average, after inflation (so if inflation is two percent, we’re talking about a six percent per year return, well under the 10 percent of the last 100 years).

For exactly those reasons, I think investing overseas is really a good idea at this point, and here Arnott and I agree (surprisingly, he didn’t consult with me).

I mentioned above that he thinks emerging markets stocks will earn high single digits (or low double digits with inflation), but he also forecasts that developed international stocks will earn 4.5 percent, after inflation. Valuations overseas are much better because people are, understandably, nervous about their economic conditions.

There is much to learn from people that you don’t agree with – perhaps more than from those that share your views.

I’ve been reading Arnott for years (see this product review I wrote on Seeking Alpha from 2011) and evaluated his products closely, but, so far, we haven’t been willing to put our own money into his strategies, so we haven’t been willing to put any of yours in either.