Many believe that we’re living in an environment of perpetually slower economic growth and potentially lower investment returns.
Due to a variety of factors, investment returns may be below what investors might have reasonably expected not long ago. However, investors’ desire for returns hasn’t changed and, as a result, many are grappling with how to achieve higher performance in more modest markets.
Investment returns are heavily influenced by “macro” factors, which are more universal than, say, the sales results of a particular company. These “macro” factors may help explain why we may be in an era of lower investment returns.
In many countries around the globe, high debt levels have burdened economies as governments face spending cuts and heavy interest payments. Aging global demographics are another factor because as populations grow older, they contribute less to economic growth and require greater government services. This trend includes the beginning of the baby-boomer retirement wave in the United States.
Since the great recession of 2008-2009, governments have been trying to stimulate economic growth through low interest rates and targeted efforts to help increase bank lending. These programs have been mostly successful – but the resulting economic growth has been well below previous recoveries as the debt burdens and demographic issues remain.
Government stimulus programs have helped to push interest rates – and bond yields – down. But the fact is that bond yields have been falling for 30 years (see chart below) so the impact of these more recent aggressive programs has been more muted.
Historically, the vast majority of return from bonds has come from the interest payments received. However, the 30 year trend of generally falling interest rates has resulted in average annual returns of about 7.4% for the Barclay’s Aggregate Bond Index thus leaving investors with diversified bond portfolios accustomed to higher returns than what today’s current yields suggest we should expect in the future.
Periods of low returns may cause investors to become more aggressive in an effort to maximize returns. Extremely low bond yields may cause some investors to venture into higher-yielding asset classes such as high-yield and emerging-market bonds. In search of incremental yield, these investors have ventured farther down the credit spectrum – forgetting how credit risk may backfire in economic downturns. During the 2008 financial crisis, high-yield bonds fell 26.2%, while U.S. Treasuries rose 11.4%. While the 2008 financial crisis was extreme, the disparate returns show the importance of diversification and portfolio construction.
Imminent Stock Market Correction?
With the slow economic growth and the dramatic recovery in stock prices since 2009, many investors are concerned over the possibility of a near term stock market correction. While such a scenario is certainly possible, it is important to note that there is no sure way to determine when a correction might arrive, or what the extent would be.
To our knowledge, there are no known or accepted indicators that successfully and consistently predict future returns over shorter-term periods such as one year. In fact, research shows that many popular indicators, including P/E ratios, GDP growth and interest rates, are not predictive over the short term at all.
To highlight this, let’s take a closer look at the price/earnings (P/E) ratio, which simply provides us with a proxy for evaluating what investors are willing to pay (i.e. the stock price) for a unit of earnings, and whether current P/E levels are indicative of future returns in both the near-term and long-term. The charts below show various P/E ratios over the past 36 years and the subsequent 1 year and 10 year forward returns of the S&P 500 from those data points.
Looking at the relationship between P/E ratios and one-year returns (left chart), we can see that the data points are somewhat randomly scattered and not particularly correlated, suggesting that P/E multiples are not a particularly good indication of short-term returns. While P/E ratios are a poor indication of short-term returns, the right chart suggests that they may be a better indicator over longer periods such as 10 years as the forward 10 year returns from stocks are more consistently much lower at higher P/E ratios.
Today, depending on what P/E measure is used, U.S. stock market valuations are arguably “full” and suggestive that investors should be prepared for lower returns in the decade ahead than those enjoyed in recent years.
Crestwood’s process – Diversification
Successful investing is as much about managing risk as it is pursuing opportunities. As we seek and evaluate investment opportunities to help meet your important financial goals, we are also focused on monitoring and controlling the risks created within your portfolios. Building and maintaining well-diversified portfolios, which strive to balance risk and reward in a manner consistent with your individual goals, risk tolerance and time horizon is an important part of your ultimate success.
The role of bonds within a diversified portfolio is to provide income while mitigating broader portfolio risk. In periods of market stress, the prices of high-quality bonds tend to move in the opposite direction of stock prices. (Note that this relationship does not hold true for high-yield bonds, which tend to fall along with stocks during market downturns.) This is just one of the many reasons we believe a well-diversified portfolio should always include some exposure to high quality bonds.
When it comes to stocks, we believe impulsive efforts to “time the market” by jumping in and out based on hunches or fears of an imminent correction are not constructive. Within our portfolio construction framework, we use market valuations and future return expectations to help guide our asset allocation mix. Market valuation measures are objective, and help to keep a clear perspective in “irrational” markets. Even with valuation tools, it is impossible to accurately predict near term market fluctuations thus we build diversified portfolios and invest for the long term.
The unpredictable nature of markets in the short term underlines the importance of creating investment plans that focus on long-term goals. And it works best when we work with our clients to carefully understand their underlying objectives so that we can most effectively build and execute a plan that meets these long-term objectives and needs.