Category: Financial Markets

  • Vanguard’s Take on the next Decade in Equity Returns is Even More Dour than AQR’s

    • Compared to Ilmanen’s, Greg Davis of Vanguard provides a more pessimistic outlook still: He expects the S&P 500 to return between 3.8% and 5.8% (mid point of 4.8%) over the next decade.
    • Note that his numbers are now nominal. To make them comparable to Ilmanen’s, we need to subtract inflation: Say inflation clocks in at 2.5% that means 1.3% to 3.3% real. That range sits below Ilmanen’s almost entirely!
    • It’s also not very different from Tips yields (1.9% 10 years out and 2.6% for the 30 year). Those of course, are also real. If you believe this, why not just buy Tips?
    • His argument largely rests on the currently elevated CAPE ratio.
    • Davis is especially concerned about US stocks and recommends a 60:20:20 blend of Fixed income, US equity, and foreign equity – a significant departure from the standard recommendation of 60 equity, 40 fixed income, with the former two-thirds or more US.
    • This coming from Vanguard is significant.

  • What’s Been Driving Equity Returns; What to Expect – via AQR

    • A great paper by Antti Ilmanen of AQR. At this point, Antti is one of the foremost experts on expected returns across asset classes (he also wrote an excellent book on the topic). 
    • A brief summary:
      • One can decompose equity returns into dividend yield, earnings growth (as a proxy for dividend growth), and multiple expansion. Those three will always fully explain realized returns over a given period.
      • US real equity returns over the very long run (6.6%) are mostly Dividend yield (~4%), some earnings growth (~2%), and a small amount of multiple expansion (.5%).
      • Since 1982 the picture has changed. The last decade especially was quite different. Real earnings were higher (9.7%), but now it’s mostly earnings growth and multiple expansion, and a much smaller dividend yield (1.7%).
      • It is doubtful that this is sustainable:
        • Multiples can’t expand forever (well, theoretically they can, but practically not really).
        • Recent high earnings growth figures can largely be explained by corporate tax cuts and drops in interest rates. Neither of those can go on forever either (we already see interest rates moving the other way).
      • Ilmanen concludes not with a specific return prediction but a wide range of ‘objectively feasible next-decade real returns’ of 3-8%.
    • Note that these are real return numbers, so add your preferred inflation prediction for nominal figures.
    • If those valuations revert and higher interest rates are here to stay, I’d say we’d look at the lower end of that range. Of course, AI could always save the day via much greater organic earnings growth…