“Where did THAT number come from?” or, “How I Learned to Stop Worrying and Love the Bomb.” (Thanks Dr. Strangelove)
The 1960's movie Dr. Strangelove, played to the fears of the cold war era and the threat of thermonuclear war. And the headlines always play to those same fears over time. It’s deja vu all over again. There is always uncertainty around the corner. But for the long term investor, its the longer term outcomes that matter the most.
There are two things that have a major influence on how the long term future unfolds for stocks and bonds: where you start from (current valuations) and interest rates. In the short run, its a crap shoot. The long run means around ten years, more or less. Not that things are steady over 10 year horizons, they aren’t, but market relationships appear smoother and a bit more predictive over that span of time. Look at the image below, it is the annual return of the SP500 over the past 100 years. The blue bars represent the return each year which look quite random. But the 10 year average, shown by the red line, reveal clear strong cycles.
Interest rates also influence investment returns and they haven't been very consistent over the past 100 plus years as shown in the graph below. Interest rates have averaged about 4.7% (10 year treasury bond) for the past 100 years, but spend most of the time above or below that.
STOCKS
It would be nice if stock prices went up year after year. But nothing tends to go in a straight line, most things are cyclical, and they go up and down around a longer term average. The SP500 has averaged a bit under 7% for the past 100 years, but in any given year it rarely returned that 7%. Even over 10 years it rarely returned the average. Things actually spend very little time at their average values. These cycles can provide a view into possible futures. When returns are well above their long term average, you can expect long term future returns to decline. This is explored in great detail in a later article called "Details" and future expectations are updated in the "Latest" tab articles.
Interest rates can affect stocks too. The qualitative argument is that as interest rates rise, yields on bonds rise from very low levels but their value declines. Bonds become more attractive relative to stocks once they start falling from those high yields. A second argument says that as interest rates rise, borrowing costs rise, so doing business becomes more expensive, and earnings decline and share price goes down as well. And a third argument is that as interest rates rise, it is because the economy is doing better and markets should go up as well.
So we’ve got competing mechanisms, some positive and some negative. With a quantitative look at the historical relationship between stocks, bonds and interest rates, it appears there may be sweet spots, where interest rates at a certain level are optimal for stocks. (The investing cognoscenti sometimes refer to this as the “natural rate”.)
BONDS
Interest rates have a more direct effect on bonds. A diversified bond fund has had average returns of 6% over the past 30 years (combined effects of yield and price) and have been a significant help in a diversified portfolio's performance. Bonds tend to move opposite stocks so they also reduce portfolio volatility. But there is a fly in the ointment. Bonds do especially well when interest rates fall. Even though the yield may drop, the value climbs. And interest rates have been mostly falling for the past 30 years. When interest rates drop to near historic lows, what has been a tail wind for bonds can become a head wind reducing total bond returns.
VUSTX, the long bond funds from Vanguard, returned 6.4% per year since the early 1990s. But more than half that total return occurred as a result of capital gains since interest rates were much higher back then than they are today. There simply isn't any way for interest rates to drop as much as they have over the past couple of decades. VUSTX return in 2019 is 2.6% per year (its current yield at the time). If interest rates stay constant that’s the total return you will get going forward. If interest rates go up, the bonds will deliver less in terms of total returns, even as yields rise. So too, for short term bonds, or aggregate bond funds (like VBMFX). For these shorter term funds, the negative impact of rising interest rates is reduced. (Its why experts recommend moving to shorter term bonds in a rising interest rate world. A simple formula can estimate future total returns of a bond fund based on different future interest rate scenarios. Here is a simple Excel estimator I built that calculates total return of a bond fund for different expectations about future interest rates.)
Conclusion:
In a nutshell when valuations are high and interest rates are rising it is not a positive for future long term returns for stocks or bonds. Over the past 25 years this is what the returns of those asset classes look like.
That 60/40 portfolio would have delivered about 8% per year for the past 20+ years (even with the tech bubble and financial crisis) and no allocation would have improved things much. (US stocks did a bit better than bonds, but with a lot more volatility.)
So what will the next 10 or so years look like starting in 2019, the time of this writing.
That 60/40 portfolio may return only 2% (+/-4%) average per year over the next 10 years if valuations cycle to historical levels and interest rates rise significantly. Year to year is very unpredictable. It could be worse or better. If we have another blow up like the financial crisis, be prepared to accept a 30% or more one year decline, even in a well diversified portfolio. Equities are starting at higher valuations so their future returns are likely to be well below historical rates. Interest rates are at historical lows, so bond returns are likely to be well below their historical rates, but bonds have much lower volatility than equities and should be an important component of any plan. So expect below average returns over the next decade and well into 2020's. Expectations will be calculated and updated in the "Latest" tab as the future unfolds.
(Keep in mind that these lowered expectations don't include the negative effects of inflation, taxes, and any other “expert” or management fees you may pay. And that earlier discussion on investment fees looms ever larger. If returns do average 2% for the next decade, that 1% management fee, starts looking like a 50% tax on your earnings.)
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