In last month’s report we addressed how we thought Katrina might affect the economy and the stock market. But over the past month, in the aftermath of Katrina’s (and subsequently Rita’s) winds, our view on one important factor, inflation, has begun to change.
We had been of the view that, for the most part, inflation was under control, but we have become concerned that inflation could rise more than we originally anticipated just a few months ago. The primary factors behind this change of heart are the anticipation of massive commitments of federal dollars to restore the hurricane-damaged areas, as well as the heightened problem of more commodity supply disruptions. It now seems likely that we will see inflation moving higher in the months ahead.
Any uptick in inflation should eventually translate into higher long-term bond yields. And higher interest rates, all else being equal, are not positive for the overall valuations for stocks or real estate, never mind a negative for economic growth.
How much higher inflation and long-term interest rates go is, of course, the big question. While these new inflationary pressures are worrisome, the bigger picture background still contains the significant deflationary forces we have discussed before: the effects of globalization (cheap goods and lower wages), high consumer debt levels (eventually that will play out in reduced consumption), and high productivity.
As we expected, in September, the Federal Reserve decided to hike short-term rates another 25 basis points (0.25%) for the 11th consecutive time since they started on their program of “removing accommodation” last June. This brought the Federal Funds rate up to 3.75% and sent the bond market an important signal that they are still vigilant about inflation. While we saw the yield on the 10-year Treasury move up to 4.32% from 4.01% at the end of August, had the Fed “paused” in September, we believe the long-term bond yields would have gone even higher.
In summary, the risk of increased inflation makes us view both stocks and bonds (as well as real estate and the economy) less favorably than a month ago.
More Subdued Returns
We have discussed before how the next decade (or more) is likely to offer more subdued returns from conventional asset classes such as stocks and bonds. The reasons for this forecast relate to historical yields, dividends, valuations (P/Es), economic growth and inflation.
Rusty addressed the overvaluation issue in his June Research Perspectives: Investing Lessons For The Next 20 Years.
“The table at right, from an excellent study by Crestmont Research, is quite illuminating on this point. They calculated the returns of the S&P 500 over the 85 different 20-year periods from 1913-2003 and ranked them by deciles from the worst 10% of 20-year returns up to the best 10% of 20-year returns.
“As highlighted, the two worst 20-year average periods — with average annual returns in low single
digits — began with high valuations (P/Es of 18 and 19) and ended with low valuations (P/Es of 9). While the three best periods — with average annual returns over 10% — started with low valuations (10-12) and ended with high valuations (18-29).
“The returns from the market over the past 20-years fall into that rarified best 10% of all time. Whereas, if we look out towards the next 20-years, we find that we are starting with a market P/E of around 20, which in the past has meant a period of low to mid-single digit returns.”
Another approach to looking at future stock returns is to break down the three components of stock returns — earnings growth, dividends and valuation level changes (P/E expansion or contraction) — and look at the outlook for each one individually. This yields a similar answer.
From 1926 to 2004, the average annual return of the stock market according to Ibbotson was 10.4%. Over that period the return breaks down as follows: earnings growth averaged 5%, dividend yield averaged 4.5% and P/Es doubled from 10.2 to 20.7, which contributed 0.9% to the total.
Now when we look forward, two things stand out. First, P/Es are not likely to go higher. The long-term average P/E is 15.8 and today we stand at 18.5 and heading down. So at best we can expect no contribution from P/E increases (and in fact a decrease in return from further P/E contraction is more likely).
Second, dividend yields are currently well below the long-term 4.5% average at just
under 2%. Why are dividends so low? Because valuations are high. Companies typically pay a relatively fixed percentage of earnings in dividends, regardless of the price of their stock. So for example a company that earns $2.00 in earnings per share might pay out $1.00 per share in dividends. If the P/E ratio on the company’s stock is 10, the stock sells for $20.00 and the dividend yield is 5%. But if the P/E ratio is 20, then the stock sells for $40.00 and the dividend
yield falls to 2.5%. So we are unlikely to see a significant boost in dividend yields unless P/Es fall which would, of course directly offset the benefit of higher dividend yields.
The last component is earnings growth. Over the long-term, corporate earnings grow at
about the same rate as nominal GDP (real GDP plus inflation). With real GDP growth relatively constant, and the Fed much better at controlling inflation, nominal GDP is expected to grow at 4%, (about 1% below its long-term average), and corporate earnings should grow at about the same rate. As with dividend yields, should inflation increase from here, thus raising nominal GDP above 4%, the benefits to earnings growth will be offset by a decrease in P/Es.
Add it all up — 4% earnings growth; 2% dividend yield; and assuming no change in P/E — and you get 6%.
One final way to look at the issue is interest rates. When interest rates have been low — as they are today with the 10-year Treasury yield at 4.39% (shaded area) — the return from stocks over the next 10 years was low and vice versa.
This makes sense as stocks tend to do well when rates are falling and have trouble when rates are rising, so the higher rates are when you start, the more room they have to fall.
So no matter how you look at it, the returns from stocks over the next decade are likely to be a lot closer to 6% than the long-term average of 10%.
At the same time, due to the powerful effects of globalization as wrought through the emerging markets of Asia and elsewhere, bond yields are unlikely to move substantially higher from here. The best estimate of a bond’s total return is its current yield, which (based on the 10-year Treasury) suggests a return close to 4% for bonds.
Historically, stocks have been riskier than bonds, by virtue of their lesser claim against a firm’s assets than bonds, and by their higher volatility. As such, they have also historically generated returns about 5%-7% higher than bonds. While stock returns will in all likelihood still offer higher returns than bonds going forward, as we saw, the degree of outperformance will likely shrink. This suggests that more balanced portfolios (i.e. those with a larger allocations to bonds than “normal”) will offer a better risk-adjusted return.
Improving Your Odds
Does this mean you should not be investing today? Not at all. If one has the resources, risk tolerance (capacity and attitude), and long-term objectives such as retirement, then one should be an investor. Don’t be tempted to time the market. It may seem with all that’s going on, including plunging consumer confidence, that now is a lousy time to invest. But it’s often better to invest when things look bleak rather than great, and the reason most investors fail to achieve the returns they should is that they are out of the market “waiting for it to get better.” In short, given the financial market's long-term positive expectations, it is always better to start investing today rather than tomorrow.
Nor should this analysis suggest that you have to settle for low- to mid-single digit returns. There are a variety of ways in which an intelligent investment advisor (I humbly hope that Kobren Insight Management would fall into this category) can add value to the basic mix of stocks and bonds and improve the odds that your portfolio will outperform those averages.
For example, rather than limiting one’s investment universe to only large, well-known or established mutual funds, we will prospect among small and newer funds if we believe in the manager’s skills, investment philosophy and strategy. And regardless of the age or size of a fund, identifying superior active portfolio managers can add value. Making tactical asset allocation shifts based on changes in long-term relative valuations could also be beneficial over time.
Taking An Alternative Approach
Looking outside that particular box of conventional U.S. stocks and bonds is especially important in building your portfolio. The simplest and most practiced form of this is simply to add foreign stocks and bonds to your holdings. We have favored international exposure for several years and continue to do so. The simple reason is that many foreign markets offer a better value (i.e., lower P/Es or higher growth rates — or both in the case of emerging markets) than the U.S. market. Despite a strengthening dollar which has risen around 10% this year versus a basket of major currencies, the MSCI EAFE Index has gained 9.1% versus the S&P 500’s 2.8%.
And, we remain long-term bears on the dollar as well. Despite better comparative interest rates than recent years, our twin deficits are truly outliers on the global economic stage. According to noted market commentator, participant and author Jim Rogers, the U.S. now owes the world over $8 trillion - and that number is increasing over $1 trillion every 15 months! To put it politely, the “reconciliation mechanism” for these deficits is generally a weaker dollar.
A weaker dollar should translate into stronger returns abroad (assuming the international fund or security is un-hedged), in international stocks and bonds, as well as developed and emerging countries. In particular, we are still long-term bulls on emerging markets, especially the equities, but like the case in natural resources, these markets have had very nice runs this year and could probably use a breather. Patience is in order.
Another nontraditional area that we have employed with good success more recently is commodities. Commodities have received a lot of attention this year with the sharp spike in oil and gas prices, but commodities are more than just energy. In fact, energy makes up about 1/3 of the AIG Dow Jones Commodity Index, with agricultural products making up another third and metals (including Gold) making up the last third.
We are believers in the long-term story for commodities due to strong global demand and limited supply due to lack of investment in recent years. It is also important to note, that just like stocks and bonds, commodities also have bear and bull markets. Quoting Jim Rogers again, the shortest bull market in commodities was 15 years, and the longest was 23 years. We are only four years or so into this bull market.
That said, we do not think this is a good time to jump into fresh commodity positions and chase the strong performance of late. In fact, according to Lipper, natural-resources funds have attracted nearly $10 billion in net new money this year through August — more than the total for all U.S. diversified stock funds. Note that this data does not even include the flows from September, which will surely include another strong net flow into natural-resource funds.
We remain committed to the asset class, due to its long-term return potential and powerful diversification benefits, but prefer again to be patient and add to positions on future price weakness (such as we have just started to see in the first part of October).
In summary, over the next 10 years, while we may not be so fortunate as to enjoy 18%+ annual gains on our investments as in the past decade, it is in times of more moderate returns that a skilled investment advisor can actually add the greatest value to your portfolio. We remain grateful that you have placed your trust in our firm to deliver on that promise.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio ManagerCo-Portfolio Manager
