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Disrupted Expectations

The first half of 2018, like in any year, contained many challenges and surprises for investors. For example, investors were confronted with certain threats to equity returns, specifically, the Federal Reserve raising interest rates and tightening liquidity by starting to unwind its balance sheet, rising oil prices and threats of a global trade war, which also led to collapsing prices in some commodities.


Among the “surprises” were that, even though many investors had declared the size premium dead, U.S. small-cap stocks outperformed. For instance, using data from Morningstar, the Vanguard S&P 500 ETF (VOO) rose 2.7% this year through June 30 and the Vanguard S&P Small-Cap 600 ETF (VIOO) climbed 9.3%. That recent outperformance follows poor performance over the seven-year period 2011 through 2017. Using Fama-French data from Dimensional Fund Advisors, the annual size premium in the U.S. was negative in five of those seven years, with returns of -6.0%, -1.2%, 7.3%, -8.0%, -3.9%, 6.6% and -4.8%, respectively. The annualized premium was a negative 1.4%.

Another such “surprise” to many was the poor performance of developed international and emerging market stocks given their lower valuations and thus higher expected returns.

As just one example, GMO, whose chief investment strategist is the oft-quoted Jeremy Grantham, in its latest seven-year forecast stated: “To us, the opportunity set for equity investors looks pretty clear: favor non-U.S. markets, especially value stocks in emerging markets.” While, as I previously mentioned, Vanguard’s S&P 500 ETF, VOO, rose 2.7% over the first six months of 2018, and again using Morningstar data, the Vanguard FTSE Developed Markets ETF (VEA) lost 2.7% and the Vanguard FTSE Emerging Markets ETF (VWO) lost 7.2%.

A third “surprise” for investors was that the first half of the year saw strong returns to the U.S. momentum factor. If that performance holds up for the full year, Fama-French data shows it will be the seventh year of positive returns to the momentum factor over the last nine (only 2012 and 2016 showed a negative premium). Since 2010, the annualized premium has been about 4%.

Forward-Looking Returns: What Should Investors Expect?

Research on the expected equity premium, including Aswath Damodaran’s paper, “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” has found that the best predictor of future equity returns is current valuations—whether using measures such as the earnings yield (E/P) derived from the Shiller CAPE 10 (or, for that matter, the CAPE 7, 8 or 9) or the current E/P—not historical returns.

His review of the evidence led Damodaran to conclude: “Equity risk premiums can change quickly and by large amounts even in mature equity markets. Consequently, I have forsaken my practice of staying with a fixed equity risk premium for mature markets, and I now vary it year to year, and even on an intra-year basis, if conditions warrant.”

With that in mind, let’s examine the earnings yield (the inverse of the commonly used price-to-earnings, or P/E, ratio) based on the CAPE 10 ratio as of June 30, 2018, for three equity indexes pertinent to our discussion thus far: the S&P 500 Index, the MSCI EAFE Index and the MSCI Emerging Markets Index.

Earnings Yield & CAPE 10

The E/P provides an estimate (which should be treated only as the mean of a wide potential dispersion of potential outcomes, not as a predetermined, inevitable or even a likely outcome) for the real returns to equities in these three markets. According to data from AQR Capital Management, the earnings yield was 3.2% for the S&P 500 Index, 5.2% for the MSCI EAFE Index, and higher still at 6.6% for the MSCI Emerging Markets Index.

In each case, and again based on data from AQR, the earnings yield was up slightly from its year-end 2017 figure—0.1 percentage points higher for the S&P 500 Index and MSCI EAFE Index and 0.3 percentage points higher for the MSCI Emerging Markets Index, as weaker performance of emerging markets raised expected returns the most.

To get the nominal expected return, my firm, Buckingham Strategic Wealth, adds in the difference between the current yield on the 10-year Treasury and 10-year TIPS, currently about 2.1%. That produces nominal expected returns of just 5.3% in the U.S., 7.3% in developed non-U.S. markets, and 8.7% in emerging markets. Each of these is well-below their respective historical returns.

Before moving on, it’s important to note that higher valuations of U.S. equities reflect the view that, in the collective wisdom of investors, the stocks of other developed nations are riskier, and the stocks of emerging market countries are riskier still. In other words, the higher expected returns of international stocks does not mean they are better or more attractive investments, just more risky ones. It does mean, however, that because current valuations represent the best estimate of future returns, investors seeking the safety of U.S. stocks are accepting lower expected returns.

The bottom line is that current valuations present problems for investors relying on historical returns in their retirement plans.

Depressed Yields

Creating further problems is that bond yields remain depressed. The five-year Treasury bond, for instance, is yielding about 2.8% as I write this. Let’s see what these estimates mean for a “traditional” 60% stock/40% bond, U.S.-centric investor.

The traditional 60% stock/40% bond portfolio, using publicly available, low-cost mutual funds, performed extremely well over the last 36 years—a period that included two of the worst bear markets in U.S. history. From 1982 through 2017, a period that begins with a bull market and a peak in interest rates, a portfolio allocated 60% to the S&P 500 Index and 40% to five-year Treasury bonds returned 10.4% a year with volatility of 10.2%. Note that 10.4% return was almost 2 percentage points per year higher than the portfolio’s 8.5% return (with volatility of 12%) over the full, 90-year period 1928 through 2017 (the longest time frame for which data was available).

Unfortunately, simple mathematics makes it clear that today’s investors (including pension plans and endowments) are faced with a harsher reality. Those returns, from what might be called a “Golden Era,” are not likely to be repeated. The reason is that returns benefited from three favorable tail winds (stock valuations rose, profit margins rose to record levels and bond yields fell), none of which is likely to recur. Meanwhile, the risk of mean reversion exists.

With an expected return of 5.3% for U.S. stocks and a 2.8 expected return on five-year Treasury bonds, a 60/40 portfolio has an expected return of about 4.3%. That’s more than 6 percentage points below the return over the prior 36 years and more than 4 percentage points below the 90-year results.

Investors can increase their expected returns by adding exposure to small-cap and value stocks to capture those premiums, and by increasing exposure to international developed markets and emerging markets stocks. However, there’s no way they should expect to earn returns similar to those earned over the prior 36 years. As I mentioned previously, this reality creates problems for those counting on historical returns when designing their investment plans.

On that note, I recently spoke to a financial professional who asked my thoughts on a client’s retirement plan. The advisor was using historical return assumptions in his Monte Carlo analysis. I told the advisor that doing so presented an overly optimistic view of likely outcomes and created a dangerous situation, in this case because the client was withdrawing 6% and had a significant chance of running out of money. That conversation spurred me to write this article. Forewarned is forearmed.


Those retiring today have benefited greatly from the tail winds I discussed. However, those now planning for retirement face much greater challenges. That likely means many will have to save more, plan on working longer, and should at least consider increasing their equity exposures to factors that historically have provided premiums and can also provide diversification benefits. Such investors may also consider increasing their exposure to international equities, perhaps overcoming a home-country bias.

Larry Swedroe is the director of research for The BAM Alliance.   

This commentary originally appeared August 6 on ETF.com.

This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice.  By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by the author are their own and may not accurately reflect those of Beacon Hill Private Wealth LLC. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

Past performance is no guarantee of future results. There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.

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