John Bogle’s formula says 1% real stock returns likely over next decade

[Steve Reading]

[Comments removed by moderator oldcomputerguy]

The predicted growth is composed of three factors.

1. Dividends
2. Earnings growth
3. P/E multiple speculation.

The first, dividends, is a matter of historical record, and has been low and stable for some time. If you think dividends are suddenly going to explode past 2%, feel free to explain why.

The second is a fairly steady trend, and the example just used it. If you think earnings growth will accelerate going forwards, when we're already getting warning shots about the coming quarter, and the rest of the world is clearly slowing down, well... OK, reasons why we'll see that please. Perhaps you know of some new paradigm shifting tech or something.

The third doesn't have to relate to CAPE at all. Simply explain why you think even higher P/E ratios are coming from their already lofty perch, and why, including why you just abolished reversion to the mean.

That's all you need to plug into the equation. The point is simple; Bogle used what he decided were the most sensible inputs into the EQ, giving what's most likely to happen in his opinion. His call has been confirmed since start of Jan 2018, so your new inputs should be able to do better - predict the 2018 onwards stagnation stretch, plus what happens going forward from now, last q 2019. Listening carefully

For VPU (utilities)
Dividends right now = 2.8%
Earnings growth rate = 6.6%

For information tech (VGT)
Dividend = 0.4%
Earnings growth rate = 12.5%

Etc

Even if earnings growth and multiples stay the same, the return should be very good.

Even if we assume earnings growth slows down to just inflation, that's still a real return of ~3.5-4.6%. That's about the floor return I'd consider sensible to expect. Not 1%.

You get 1% real by assuming far lower earnings growth than current AND a multiples contraction. These are both somewhat speculative expectations and I couldn't care less about them.

[petulant]

[Comments removed by moderator oldcomputerguy]

The predicted growth is composed of three factors.

1. Dividends
2. Earnings growth
3. P/E multiple speculation.

The first, dividends, is a matter of historical record, and has been low and stable for some time. If you think dividends are suddenly going to explode past 2%, feel free to explain why.

The second is a fairly steady trend, and the example just used it. If you think earnings growth will accelerate going forwards, when we're already getting warning shots about the coming quarter, and the rest of the world is clearly slowing down, well... OK, reasons why we'll see that please. Perhaps you know of some new paradigm shifting tech or something.

The third doesn't have to relate to CAPE at all. Simply explain why you think even higher P/E ratios are coming from their already lofty perch, and why, including why you just abolished reversion to the mean.

That's all you need to plug into the equation. The point is simple; Bogle used what he decided were the most sensible inputs into the EQ, giving what's most likely to happen in his opinion. His call has been confirmed since start of Jan 2018, so your new inputs should be able to do better - predict the 2018 onwards stagnation stretch, plus what happens going forward from now, last q 2019. Listening carefully

Hey man, you started the thread and asked for opinions. You're being a bit cheeky here saying other people need to prove CAPE wrong. We've already provided some reasons for it being messed up.

I have no problem with using current PE in the exercise you mentioned. And I have no problem using dividends, buyback yield, etc. to get some conservative expectations. Thing is, those are not going to say 1%. For CAPE to be meaningful and get 1%, you have to assume significant earnings declines or PE contractions (reversion to mean) that are not reasonable given our circumstances. I've posted some information about that but you still haven't engaged.

[rich126]

Over the last 12 months 1% would look good compared to the 1 point the SPY has risen (287.4 to 288.5). I think that is about 0.3% for the year ending 10/8/2019.

I wouldn't be surprised if the market has a rough decade. [snip]

Nice thoughts, thanks. Mind sharing your asset allocations in more detail? I agree with pretty much everything you pointed out...

People invest in different ways. Obvious many/most here are strong proponents of investing and forgetting about it (mostly, anyhow). I'm not a fan of Efficient Market Hypothesis although I do think for many, it is probably their best option. To me it goes against common sense. It would be like telling me in school (or sports) that I can only be average and there is no point in trying to be better than average.

Anyhow I think for anyone young you can just throw it into the market (preferably a mixture of US and World stocks and rebalance at times) but as you get closer to retirement you have to be more careful since big losses can kill your retirement. I got away from mutual funds many years ago because I didn't like the taxes I had to pay on them, and the fees were higher decades ago.

Currently I think using anything similar to the all weather/permanent type portfolios is the safest thing to do until things in the world settle down a bit (if they ever do). Mixture of long term treasuries (I don't see inflation/rates climbing although I will keep an eye on political stuff but that isn't a good topic here), gold (not a big fan of it but it seems to work), stocks (US and international). Maybe 40-50% stocks, 20% LT, 20% gold, 10-20 short term treasuries. And be flexible on the LT/ST treasury percentages, if things seem to be changing go more ST and less LT. And if the market is looking better then adjust a bit upwards.

I've only bought bonds/bond funds recently. In the past it was strictly individual stocks and cash. In the past year just to diversify some I did move a chunk of money (~20-25%) into funds such as Wellesley, Wellington and Moderate growth to gain some international and bond diversity. Most of my money is concentrated in about a dozen stocks. Some will think that is high risk but I put that into fear mongering. Quality stocks can and do go bankrupt but not over night and you have plenty of time to get out.

I have Apple, Google, Facebook, USB (bank), and a bunch of Berkshire stock. I'll sell some when things seem peaky, and buy more when there is a drop due to market reasons and not individual stock reasons. It has done reasonably well over the last decade despite holding a decent amount of cash at times. I don't expect to buy at the low point or sell at the high point but just get in the general vicinity. Right now I'm looking to get more long term treasuries.

You got to invest in what makes sense for you and something you can be consistent with. While many here may be able to hold to an asset allocation through thick and thin, most people I know tend to panic when the market drops, then sell things, and don't get back in until they missed a ton of the gains. I've learned my lessons a while ago and am happy where I'm at. I'm not looking for the big gains any more, I'm more concerned with a 30% drop just prior to retirement. Some here have tons of money and worry about a 2% SWR, most people in the real world have bigger worries.

Good luck and consider what works best for you.

[Steve Reading]

My question is, why? Why would we expect the future to be different than the past? I know we often say the past does not indicate the future, it then I also question, we’ll, why do we think it’ll be radically different?

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

[JackoC]

Bogle had a record of consistently underestimating stock returns. If you'll pardon the metaphor, even a broken clock is right twice a day. This no disrespect for the gentleman that Bogle was.

If you don't rate his abilities, why are you on a Bogle forum?

Anyhoo, you don't have to agree or disagree with Bogle. All you have to do to invalidate the idea is point out why the formula is wrong. Or why the inputs into it need tweaking. Which would involve explaining why you think earnings will grow more rapidly, or why multiples will expand past the currently high level.

He already did. The P/E implies a 4.6% return rn. Since earnings grow at least at the rate of inflation, that represent 4.6% real return. The CAPE imples 3.5% real.

The 1% comes because the author assumed a reversion of the mean P/E (valuations get better). This is a speculative return which has nothing to do with fundamentals.

I agree the derivation by which the dividend discount model is rearranged to give E[r]=1/PE is fundamental only. It neglects any speculative return from PE changing. Therefore a common reason estimates of expected return to be lower than 1/PE is the assumptions PE's (or CAPE) will revert from currently high values more to historical mean. Although, that's not the only assumption one might make to get a lower/higher estimate. Self plagiarizing from a previous post that explains where the idea E[r]=1/PE=E/S comes from:
"The price of a stock S=Div/(r-g) S the stock price, r the return, and g the dividend growth rate, or IOW r=S/Div+g, the return the perpetual payout of the dividend plus dividend growth. .. we take these terms to be real (ie inflation adjusted)
But dividend growth comes from earnings growth comes from return. Assume in equilibrium the real expected return on the stock is the return on capital of the company.
So restate the first equation as S= p*E/(r-(1-p)*r), where p is the payout ratio, ie Div=p*E, div growth rate is (1-p)*r
Simplify and you get r=E/S"

The quasi-sleight of hand 'we take these terms to be real' actually has some complications as to the effect of real v nominal debt, inventory, depreciation etc. The simple assumption is that that all washes out, some academic papers have looked at whether it really does.

But another related assumption there is that the depreciation charge is the actual cost to maintain zero earnings growth. Historically that hasn't been true: companies needed to reinvest some 'earnings' for future real earnings growth not to be negative (as opposed to the theoretical assumption that 'earnings' is the free and clear profit that could be entirely distributed each year and the company maintain its real earnings constant indefinitely, I think most observers intuitively realize that's optimistic). Also note that derivation doesn't end up caring what the dividend or payout ratio is, those drop out, so buybacks aren't directly relevant to it either.

Anyway I agree negative expected speculative return is likely a component in an estimate of overall US stock expected return that's only 1% real. Various prognosticators are upfront about that, it's the assumption of Research Affiliates' expected return estimates where US large cap is estimated 0.5% real, DM non US 5.4% EM 7.4%. Which *are* predictions, as I'd see it.

A straight earnings yield is not a 'prediction' as I'd see it. It's a benchmark of expected return under particular assumptions. For my planning purposes I assume expected return of US stocks is 1/CAPE, so around 3.5% real as you say. On the somewhat separate topic of US v foreign I believe it's better to diversify globally at this point even if one has benefited by not doing so up to now, not necessarily to literally believe projections like RA's that foreign will have several % point higher returns.

I would also say though that some people seem to want to have it both ways on the speculative return. Positive speculative return, namely tendency to valuation *increase* particularly in US in recent decades is the main reason the supposed 'prediction' of the CAPE has been 'wrong', or anyway why the correlation of CAPE to subsequent realized return is not super high. But then one can't IMO say a negative expected long term speculative return is an absolutely invalid assumption about the future. Is it really equally likely the CAPE will rise more than fall? That's the rough assumption of no speculative return. Again I use just 1/CAPE but I think people dismissing that as significantly too low are whistling past the graveyard.
https://interactive.researchaffiliates. ... e=Equities

[ukbogler]

Hey man, you started the thread and asked for opinions. You're being a bit cheeky here saying other people need to prove CAPE wrong. We've already provided some reasons for it being messed up.... I've posted some information about that but you still haven't engaged.

I'm not 'engaging' because your 'information' seems to be 'it's different this time'.

Here's the relevant bit from the second article (which is clearer, and has more detail)

"Reasonable investors look to actual, sustainable cash flows as a touchstone, because over the history of the world’s stock markets the real long-term rate of return has ranged from 4-7%, as delivered by earnings growth and dividends. Anything in excess of that is a temporary consequence of the crowd paying more for each dollar generated by the underlying businesses. Long stretches of high returns must be followed by low or negative returns to bring the indices back to their sustainable long-term trendlines. For the S&P to return to the mid-range of historical valuation right now would require a decline of 40% or more (taking today’s historically high profit margins into account, this might be 60%), but if multiples come down over time, earnings growth and dividends can catch up to prices."

[Forester]

I am puzzled as to why an individual who believes returns will be low single digits over the next decade, why would they buy stocks at all. Effectively this person is stating that they expect a good chance of 3% a year, with a fair chance of a 50% drawdown at some point! Those of us who allocate seriously to trend following don't care if the CAPE is 50 or 5, but I don't quite comprehend the mixture of pessimism & complacency that the buy & holders have. Perhaps negative yielding bonds will bail them out when they sell to a greater fool?

[ukbogler]

I am puzzled as to why an individual who believes returns will be low single digits over the next decade, why would they buy stocks at all.

As I understand it, he's also a trend follower, and rotates into and out of stocks when they cross some arbitrary trend line. He also splits his portfolio between stocks, int stocks, commodities, gold, corp bonds...

He's basically just reiterating what Bogle said, that prices are too [deleted] high, and as it's unlikely we'll see a doubling of dividends or major outperformance in earnings growth compared to its long term trend over the next decade, you have to face either 10 years of [bad] returns or a crash somewhere along the way that gives the market a chance to pullback and take another run up. The second of those two options seems the most likely, to him, and I agree - I can't imagine US investors meekly accepting 1% total returns yearly from their S&P ETFs for a decade.

[Edits by moderator oldcomputerguy]

[JackoC]

I am puzzled as to why an individual who believes returns will be low single digits over the next decade, why would they buy stocks at all.

As I understand it, he's also a trend follower, and rotates into and out of stocks when they cross some arbitrary trend line. He also splits his portfolio between stocks, int stocks, commodities, gold, corp bonds...

He's basically just reiterating what Bogle said, that prices are too [deleted] high, and as it's unlikely we'll see a doubling of dividends or major outperformance in earnings growth compared to its long term trend over the next decade, you have to face either 10 years of [bad] returns or a crash somewhere along the way that gives the market a chance to pullback and take another run up. The second of those two options seems the most likely, to him, and I agree - I can't imagine US investors meekly accepting 1% total returns yearly from their S&P ETFs for a decade.

This particular back and forth assumes there's some better return than the market return. That basically rejects Bogle's ideas. As the other poster said, people who believe they can time the market (in a general sense that includes 'trend following') needn't care if expected returns of the market are high or low: because they know how to beat the market.

But BH's basic idea is you *don't* know how to beat the market. Therefore you will 'meekly accept' what it returns. Doesn't mean you'll be happy if it's low, BH ism tends toward cheeriness generally but the actual principal doesn't require you to end up happy. Anyway neither side of the argument of whether you can beat the market should actually base allocation on absolute expected return being 'too low'.

The gray area in a BH framework would be non-US stocks. It doesn't directly violate BH principals (as opposed to maybe certain John Bogle personal opinions) to diversify internationally in stocks even if in part motivated by believing foreign stock USD expected returns are higher than US stock expected returns. Likewise it's not violating BH principals IMO to diversify somewhat into rental real estate or other risk assets besides stocks. As for bonds, take the neutral (IMO) expected return estimate for US stocks of 3.5% real. The 30 yr TIPS yield is 0.5%. It's not so puzzling IMO why someone who accepts what the market offers would have an allocation to stocks and not just bonds. If the US stock expected return were actually 1% or less, OK that would become a conundrum v bonds. But it doesn't seem like a lot of posts in the thread actually accept the 1%. As mentioned, the author is apparently someone who thinks their trading strategy can beat the market, a basically anti-BH view (not saying it's wrong in all cases nor that I believe it either). Research Affiliates who I mentioned project US large cap E[r] at 0.5% but EAFE 5%+ and EM 7%+ which tends to imply a big allocation shift out of US (they also project EM local bonds over 4%, EM cash over 3%, USD real returns next 10 yrs).

[usagi]

I understand the dynamics of the markets, growth, etc. but fundamentally the value of an equity or basic of equities is a factor of the return and the risk one is willing to take to get that return. Has the risk profile of people and large holders actually changed? Am I will to take on equal or more risk for less return over a lower-risk/lower-return option? Why is the spread between lower risk and higher risk options going to dramatically decrease? Why will people be willing to take on equal or higher risk for lower returns? Unless the argument is "well, that's all you're going to get..." I'm not sure how that was any different over any of the 100+ years back. Why will risk profiles change?

and

I am puzzled as to why an individual who believes returns will be low single digits over the next decade, why would they buy stocks at all.

I short I am accepting the market return but altering my asset allocation to adjust my expected return by tilting toward equities. To compensate for the added equity risk, I am increasing the asset base required for retirement reflected in the number of years my expenses are covered by my assets.

A great deal of my investment assets are taxable so the prospects of an inflation adjusted negative return on 40 percent of my portfolio is exceedingly unappealing.

[ukbogler]

But BH's basic idea is you *don't* know how to beat the market.

Agree. Which is why I referred to the fella as 'mad'. The article though is different, seeing as he just cribbed it from Bogle's book, and I thought it might spur some thought as to whether overweighting the USofA was such a great idea in the current climate.

It seems to have done something else though, bringing out spreadsheetheads who don't 'believe' in running averages, such as a 10 year P/E.

Anyhoo, AFAICT, if you were just to buy VWRL or similar, you'd automatically be overweight US, because it makes up about 50% or more of the index. If you actually wanted to bring your US weighting down, you'd balance VWRL with EAFE or something equivalent until you got the figure you wanted.

So in summary, it's just about asset allocation, is all.

[Jags4186]

I simply have a hunch that returns will be good for the next 10 years or so. I have no math to back this up. But you need to ask yourself if you think that on 12/31/2029 we will have just completed the *worst* 30 year period in US equity performance. Not a bad one, not a not so great one, but the absolute worst. Because unless we continue to have great returns for the next 10 years, that is what we will have just gone through.

Isn't that just cherry picking the start point though? No offense. I certainly am not going to defend CAPE or anybody's crystal ball. I am willing to bet stocks go up and down and just be satisfied with that.

I took 2 minutes and looked for the highest 30 year returns ever and I get 1969 to 1999. I was using some data set that started in 1926. So to further waste our time, would anybody expect the best 30 year returns to be followed right then immediately by the lowest 30 years? That's not totally stupid. My 5 minute analysis anyway.

Sure it’s cherry picking the start date (1/1/2000), but I’m not comparing it to any other random 30 year period. I’m comparing it to all of the 30 year periods. And we are on pace for the very worst. So you can say I’m cherry picking, but what matters to me most is the period I live in...and it appears we are in the absolute worst period for being an investor. Except of course if the next 10 years are fabulous and we move up to a merely “average” 30 year period.

[Alaric]

When bonds and fixed interest are returning their historical 5.5% to 6%, an equity P/E ratio higher than ~15 becomes hard to defend. But when bond returns are below 2% and some government bonds have negative returns, a stock P/E of 20, 25, or even higher begins to seem quite reasonable. Should P/E be expected to revert to its long-term mean at some point? Sure. But probably not while fixed rates hover near zero.

[Hydromod]

I'm loving all the people banging on about chi squared tests and how 'CAPE is unimportant'



It looks like a fairly useful correlation to me...

Here's the one without CAPE I've been alluding to. It is just the ratio of US stocks to all investments versus future 10-year returns. The fellow that developed it was reacting against issues with CAPE and I would argue that he came up with a much stronger relationship than shown in the CAPE plot.



The underlying data points from an online chart updating the prediction.



I have two lines through the points: a regression line and a "center-of-the-cloud" alternative trend line. The alternative trend line is my attempt to compensate for the heavier weighting of the data points with low equity fraction.

The original author explains the fit as having nothing to do with price to earnings. Instead, the rationale is that investors have to invest in something; prices adjust to accommodate the desire of investors to be invested in something regardless of the price to earnings ratio.

I would say from the scatterplot that the cloud of all quarterly observations since 1946 is consistent with a future 10-year CAGR equally likely between -1.5 to 5.5 percent, starting in July, and unlikely to see something outside that range. I did the analysis for returns a little differently, and came up with -3.3 to 4.7 percent. The current situation is out towards the extreme, so uncertainties are larger.

Clearly, the future is murky. But a range of 1 +/ 4 percent for the next decade is absolutely reasonable as a forecast.

[willthrill81]

I simply have a hunch that returns will be good for the next 10 years or so. I have no math to back this up. But you need to ask yourself if you think that on 12/31/2029 we will have just completed the *worst* 30 year period in US equity performance. Not a bad one, not a not so great one, but the absolute worst. Because unless we continue to have great returns for the next 10 years, that is what we will have just gone through.

Isn't that just cherry picking the start point though? No offense. I certainly am not going to defend CAPE or anybody's crystal ball. I am willing to bet stocks go up and down and just be satisfied with that.

I took 2 minutes and looked for the highest 30 year returns ever and I get 1969 to 1999. I was using some data set that started in 1926. So to further waste our time, would anybody expect the best 30 year returns to be followed right then immediately by the lowest 30 years? That's not totally stupid. My 5 minute analysis anyway.

Sure it’s cherry picking the start date (1/1/2000), but I’m not comparing it to any other random 30 year period. I’m comparing it to all of the 30 year periods. And we are on pace for the very worst.

That's highly debatable. The worst 15 year period for retirees, the returns of which Kitces found to be highly correlated (r = .91) with 30 year SWRs, had annualized returns for 60/40 AA under 1%. There isn't much credible work to suggest that a 60/40 is currently on pace to return under 1% for the next 15 years. Even if bonds returned 0% real over that period of time (and TIPS can be used to essentially guarantee slightly better than that), stocks would only need a real return of about 1.7% to beat the worst in U.S. history.

[alex_686]

(Not that CAPE even matters for the formula calculation)

As I understand his reasoning, he uses CAPE because he's trying to extrapolate a decade into the future. Extrapolating 10 years using a single previous year's P/E is kind of brave. Hence use the CAPE because it's an average that reveals the trend.

This simply isn't true. Using the previous year's PE has a r^2 of 0.38. Using CAPE10 has an r^2 of 0.43.

Using the previous year's P/E isn't "kind of brave" it is only very marginally worse than using CAPE10. And both are bad. Switching to CAPE10 isn't some massive, magic improvement over just using the previous year's P/E and it isn't really more likely to show any trends.

.43 is actually pretty good.

To extend a bit, it is very good when compared to other return models.

You can actually boost the power up to .6 in a simple but not easy method. Over the past decades the revisions to earnings statements have increased earnings without affecting the Free Cash Flow to Equity. The big obvious one is that you no longer have to amortize goodwill. Factor that in, and blamb!, you get your .6 power.

[gmaynardkrebs]

(Not that CAPE even matters for the formula calculation)

As I understand his reasoning, he uses CAPE because he's trying to extrapolate a decade into the future. Extrapolating 10 years using a single previous year's P/E is kind of brave. Hence use the CAPE because it's an average that reveals the trend.

This simply isn't true. Using the previous year's PE has a r^2 of 0.38. Using CAPE10 has an r^2 of 0.43.

Using the previous year's P/E isn't "kind of brave" it is only very marginally worse than using CAPE10. And both are bad. Switching to CAPE10 isn't some massive, magic improvement over just using the previous year's P/E and it isn't really more likely to show any trends.

.43 is actually pretty good.

To extend a bit, it is very good when compared to other return models.

You can actually boost the power up to .6 in a simple but not easy method. Over the past decades the revisions to earnings statements have increased earnings without affecting the Free Cash Flow to Equity. The big obvious one is that you no longer have to amortize goodwill. Factor that in, and blamb!, you get your .6 power.

So, would CAPE10 be lower or higher with such an adjustment?

[Jags4186]

I simply have a hunch that returns will be good for the next 10 years or so. I have no math to back this up. But you need to ask yourself if you think that on 12/31/2029 we will have just completed the *worst* 30 year period in US equity performance. Not a bad one, not a not so great one, but the absolute worst. Because unless we continue to have great returns for the next 10 years, that is what we will have just gone through.

Isn't that just cherry picking the start point though? No offense. I certainly am not going to defend CAPE or anybody's crystal ball. I am willing to bet stocks go up and down and just be satisfied with that.

I took 2 minutes and looked for the highest 30 year returns ever and I get 1969 to 1999. I was using some data set that started in 1926. So to further waste our time, would anybody expect the best 30 year returns to be followed right then immediately by the lowest 30 years? That's not totally stupid. My 5 minute analysis anyway.

Sure it’s cherry picking the start date (1/1/2000), but I’m not comparing it to any other random 30 year period. I’m comparing it to all of the 30 year periods. And we are on pace for the very worst.

That's highly debatable. The worst 15 year period for retirees, the returns of which Kitces found to be highly correlated (r = .91) with 30 year SWRs, had annualized returns for 60/40 AA under 1%. There isn't much credible work to suggest that a 60/40 is currently on pace to return under 1% for the next 15 years. Even if bonds returned 0% real over that period of time (and TIPS can be used to essentially guarantee slightly better than that), stocks would only need a real return of about 1.7% to beat the worst in U.S. history.

That's moving the goal posts. I'm simply talking equity returns. But that being said, if you take a look at a 60/40 portfolio vs a 100/0 portfolio since 2000, they have performed near identically in the 5.5%-5.75% range.



And considering inflation since 2000 has averaged approximately 2.2%, we're looking at real returns in the 3.3%-3.5% range for a 60/40 portfolio since 2000. The Kitces article shows "worst case scenario" real returns all north of 4%.

[alex_686]

So, would CAPE10 be lower or higher with such an adjustment?
[/quote]

Earnings would be lower, so CAPE would be higher.

[JackoC]

I simply have a hunch that returns will be good for the next 10 years or so. I have no math to back this up. But you need to ask yourself if you think that on 12/31/2029 we will have just completed the *worst* 30 year period in US equity performance. Not a bad one, not a not so great one, but the absolute worst. Because unless we continue to have great returns for the next 10 years, that is what we will have just gone through.

Isn't that just cherry picking the start point though? No offense. I certainly am not going to defend CAPE or anybody's crystal ball. I am willing to bet stocks go up and down and just be satisfied with that.

I took 2 minutes and looked for the highest 30 year returns ever and I get 1969 to 1999. I was using some data set that started in 1926. So to further waste our time, would anybody expect the best 30 year returns to be followed right then immediately by the lowest 30 years? That's not totally stupid. My 5 minute analysis anyway.

Sure it’s cherry picking the start date (1/1/2000), but I’m not comparing it to any other random 30 year period. I’m comparing it to all of the 30 year periods. And we are on pace for the very worst.

That's highly debatable. The worst 15 year period for retirees, the returns of which Kitces found to be highly correlated (r = .91) with 30 year SWRs, had annualized returns for 60/40 AA under 1%. There isn't much credible work to suggest that a 60/40 is currently on pace to return under 1% for the next 15 years. Even if bonds returned 0% real over that period of time (and TIPS can be used to essentially guarantee slightly better than that), stocks would only need a real return of about 1.7% to beat the worst in U.S. history.

On 30 yr periods we have few of them when the world was comparable to today, meaningful ones that is which would be non-overlapping. '1969-99 is almost entirely correlated with 1970-2000, it's almost all the same data. Drawing conclusions about probabilities from past overlapping periods is basically junk statistics.

However on how you'd get 1% real return on 60/40 that's simple arithmetic and I agree pre-tax, actually 1.3% real stocks 0.5% real bonds (the long term TIPS yield) is 1% on 60/40. 1.3% as in estimate in OP article implies significant valuation decline in stocks, I don't assume it will be that bad.

OTOH some people are fortunate/unfortunate enough that most of their asset returns are subject to taxes. I figure my expected return is around 1.5% real after tax if I include taxes on unrealized capital gains, around 1.75% from heirs POV assuming the capital gains basis step up remains in the tax code so those taxes never get paid. That's starting from 3.5% real pre tax for stocks (1/CAPE), inflation plus rental yield for properties, what I'm actually earning now for fixed income in a stock/real estate/bond combo that's similar in risk to 60/40 stock/bond IMO. Without the taxes then I'd say 2.3% real for 60/40 (.6*3.5% + .4*0.5%). For my planning purposes, not to rain on anyone else's parade. Also I wonder what exactly would someone do differently if they insist expected returns are higher than that, besides feel happier at their future riches? Unless things are really disastrous people will muddle through, and I've no crystal ball to foresee disaster. I do think it's pretty clear current expected returns are lower than past realized on average though.

[Bacchus01]

My question is, why? Why would we expect the future to be different than the past? I know we often say the past does not indicate the future, it then I also question, we’ll, why do we think it’ll be radically different?

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

Didn’t answer my question. Why has our risk profile dramatically changed?

[Steve Reading]

My question is, why? Why would we expect the future to be different than the past? I know we often say the past does not indicate the future, it then I also question, we’ll, why do we think it’ll be radically different?

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

[Bacchus01]

My question is, why? Why would we expect the future to be different than the past? I know we often say the past does not indicate the future, it then I also question, we’ll, why do we think it’ll be radically different?

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

[Steve Reading]

My question is, why? Why would we expect the future to be different than the past? I know we often say the past does not indicate the future, it then I also question, we’ll, why do we think it’ll be radically different?

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

[Bacchus01]

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

But the only way for this to be true (future returns of just 2-3%, as some speculate) in the long term, is for the options (like bonds) to have negative return.

[Steve Reading]

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

But the only way for this to be true (future returns of just 2-3%, as some speculate) in the long term, is for the options (like bonds) to have negative return.

Well bond real return are already basically zero so it's not a particularly unlikely scenario. TIPs rates dipped into negative a couple of weeks back. Either way, I wouldn't know much about the expectations of those speculating such pessimistic returns as 2-3% (I'm not one of them). I think ~4.5% real return on stocks and ~0% real return on bonds going forward is about right and reasonable. That's about a 4.5% equity risk premium, which is about the historical average.

That said, maybe you are right after all and risk profiles have changed and we'll see a big change in the equity risk premium. I'm honestly not sure.

[SovereignInvestor]

I'm loving all the people banging on about chi squared tests and how 'CAPE is unimportant'



It looks like a fairly useful correlation to me...

Here's the one without CAPE I've been alluding to. It is just the ratio of US stocks to all investments versus future 10-year returns. The fellow that developed it was reacting against issues with CAPE and I would argue that he came up with a much stronger relationship than shown in the CAPE plot.



The underlying data points from an online chart updating the prediction.



I have two lines through the points: a regression line and a "center-of-the-cloud" alternative trend line. The alternative trend line is my attempt to compensate for the heavier weighting of the data points with low equity fraction.

The original author explains the fit as having nothing to do with price to earnings. Instead, the rationale is that investors have to invest in something; prices adjust to accommodate the desire of investors to be invested in something regardless of the price to earnings ratio.

I would say from the scatterplot that the cloud of all quarterly observations since 1946 is consistent with a future 10-year CAGR equally likely between -1.5 to 5.5 percent, starting in July, and unlikely to see something outside that range. I did the analysis for returns a little differently, and came up with -3.3 to 4.7 percent. The current situation is out towards the extreme, so uncertainties are larger.

Clearly, the future is murky. But a range of 1 +/ 4 percent for the next decade is absolutely reasonable as a forecast.

The data points have serial correlation so there is much less data than indicated by the graph. There are very few unique 10 year periods that would allow one to fully avoid autocorrelation issues.

[Hydromod]

The data points have serial correlation so there is much less data than indicated by the graph. There are very few unique 10 year periods that would allow one to fully avoid autocorrelation issues.

Sure. Nobody should be arguing that a general law is demonstrated and completely parameterized.

But the CAPE data has exactly the same issue, and doesn't do as well.

A key point is that, over a few large business cycles, it has taken a decade or two for large-scale changes in the equity fraction, comparable to the period of interest, and the leading returns have historically changed essentially in lock step with the equity fraction throughout (the short-term wiggles are an artifact though, as the original source takes pains to point out).

Doesn't autocorrelation at that time scale provide exactly the kind of information that is relevant here?

[Bacchus01]

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

But the only way for this to be true (future returns of just 2-3%, as some speculate) in the long term, is for the options (like bonds) to have negative return.

Well bond real return are already basically zero so it's not a particularly unlikely scenario. TIPs rates dipped into negative a couple of weeks back. Either way, I wouldn't know much about the expectations of those speculating such pessimistic returns as 2-3% (I'm not one of them). I think ~4.5% real return on stocks and ~0% real return on bonds going forward is about right and reasonable. That's about a 4.5% equity risk premium, which is about the historical average.

That said, maybe you are right after all and risk profiles have changed and we'll see a big change in the equity risk premium. I'm honestly not sure.

See, I agree with your equity projection which is, as you stated, in line with the past.

But the premise here in this thread and other places is for equity growth at just 2-3% real, and some saying much lower. Unless the risk premium collapses, people will not buy equities at those return rates and prices will then drop, bringing back long-term risk adjusted returns to historically consistent levels.

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

[bottlecap]

Mr. Bogle didn’t have a crystal ball and I would be one of the first, I imagine, to put any faith in a "formula" that purports to have future market returns figured out.

JT

[gmaynardkrebs]

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Because most investors, including most BHers, now believe that in the long run, stocks are safe investments. Historically, that has not been the dominant belief among investors.

[Bacchus01]

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Because most investors, including most BHers, now believe that in the long run, stocks are safe investments. Historically, that has not been the dominant belief among investors.

Do you have facts to support that?

[JoMoney]

Make of it what you will, but it looks to me like we could see anywhere between 2% and 13% real inflation adjusted returns over the next decade and be within the bounds of historical ranges. The mid-point would be right where we are, along a 6-7% trend...

[Steve Reading]

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

But the only way for this to be true (future returns of just 2-3%, as some speculate) in the long term, is for the options (like bonds) to have negative return.

Well bond real return are already basically zero so it's not a particularly unlikely scenario. TIPs rates dipped into negative a couple of weeks back. Either way, I wouldn't know much about the expectations of those speculating such pessimistic returns as 2-3% (I'm not one of them). I think ~4.5% real return on stocks and ~0% real return on bonds going forward is about right and reasonable. That's about a 4.5% equity risk premium, which is about the historical average.

That said, maybe you are right after all and risk profiles have changed and we'll see a big change in the equity risk premium. I'm honestly not sure.

See, I agree with your equity projection which is, as you stated, in line with the past.

But the premise here in this thread and other places is for equity growth at just 2-3% real, and some saying much lower. Unless the risk premium collapses, people will not buy equities at those return rates and prices will then drop, bringing back long-term risk adjusted returns to historically consistent levels.

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Huh? It IS possible to get an equity real return of 2% without a "collapse" of the risk premium (say it's only 3.5%, well in the historical normal) as long as cash yields around -1.5%. This isn't too unlikely as cash already yields close to 0%. I don't think it's likely; but not out of the question.

Make of it what you will, but it looks to me like we could see anywhere between 2% and 13% real inflation adjusted returns over the next decade and be within the bounds of historical ranges. The mid-point would be right where we are, along a 6-7% trend...

Yes, it bears repeating that we're talking about expected real returns. We're not actually predicting what it will be. Which means there's some associated uncertainty (aka St Dev) with these expected values.

Too many BHs think we're actually predicting what will occur. We're simply estimating the middle/average of the distribution of future returns we expect to occur. Very different

[SovereignInvestor]

The data points have serial correlation so there is much less data than indicated by the graph. There are very few unique 10 year periods that would allow one to fully avoid autocorrelation issues.

Sure. Nobody should be arguing that a general law is demonstrated and completely parameterized.

But the CAPE data has exactly the same issue, and doesn't do as well.

A key point is that, over a few large business cycles, it has taken a decade or two for large-scale changes in the equity fraction, comparable to the period of interest, and the leading returns have historically changed essentially in lock step with the equity fraction throughout (the short-term wiggles are an artifact though, as the original source takes pains to point out).

Doesn't autocorrelation at that time scale provide exactly the kind of information that is relevant here?

Don't get me wrong I think the equity fraction is much better than CAPE but not as much credible data as it may seem.

Read my posts above about CAPE...it is statistical mal practice to use that IMO.

[gmaynardkrebs]

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Because most investors, including most BHers, now believe that in the long run, stocks are safe investments. Historically, that has not been the dominant belief among investors.

Do you have facts to support that?

Yes. Robert Shiller presents the data from investor surveys in his books (Irrational Exuberance); I believe the survey results are also updated regularly on his website.

[cheezit]

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Because most investors, including most BHers, now believe that in the long run, stocks are safe investments. Historically, that has not been the dominant belief among investors.

Do you have facts to support that?

Yes. Robert Shiller presents the data from investor surveys in his books (Irrational Exuberance); I believe the survey results are also updated regularly on his website.

So the argument here is that the "Dow 30,000" scenario played out in slow-motion over the last two decades?

[gmaynardkrebs]

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Because most investors, including most BHers, now believe that in the long run, stocks are safe investments. Historically, that has not been the dominant belief among investors.

Do you have facts to support that?

Yes. Robert Shiller presents the data from investor surveys in his books (Irrational Exuberance); I believe the survey results are also updated regularly on his website.

So the argument here is that the "Dow 30,000" scenario played out in slow-motion over the last two decades?

Related, I guess, but I think the Hassert/Glassman book argued that the ERP would go to zero. I doubt Shiller (or any serious economist) believes that is likely. For one thing, there has to be some ERP simply due to the volatility of stocks over shorter time periods.

[JackoC]

Two reasons:
1) We don't know if the past is representative of true returns. No amount of past evidence is enough to conclude future occurances because we wouldn't know how unlikely the past was to have occurred in the first place. This is known as the problem of induction.
2) More practically, assets can move future returns to the present and vice-versa via speculation and earnings multiple changes. So any time period might've had 12% return due to asset swelling simply by "robbing" the upcoming period of 6% returns. So the second period would deliver 0% return while you were expecting a whooping 12% by looking at the past.

Focusing on fundamentals instead of past history tends to mitigate both of the above

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

I agree with your first point in most recent post and your two reason the future doesn't have to be like the past. In bonds this is obviously true. Is anyone really arguing that it's a fallacious 'this is time is different' argument to say you'll get 0.5% real pre-tax by investing in the 30 yr TIPS now when the past realized real pre tax return on long term bonds was 2-3% (something like that depends which bond investment exactly which period)? Yeah it *is* different now, the thing yields 0.5%. Running Firecalc on a 100% bond portfolio and saying 'no it gives me an average return of 2-3% or whatever not 0.5%, 0.5% is wrong!' is ridiculous.

I don't agree though the equity risk premium either needs to be as high as it used to be. If you think it is as an opinion that's fine, just saying it doesn't have to be. Spreads on credit risky bonds now are distinctly lower now than past historical (albeit not as long a history of apples-apples on bonds with significant credit spreads) and that's a somewhat similar risk. Again on your point of just looking at fundamentals in the world today and not having tunnel vision in the rear view mirror of past returns of a particular asset class, it's a pretty consistent scene of more capital chasing fewer opportunities for return and in efficient markets that would tend to mean lower risk premia as well as lower 'riskelss' return. Like in all the threads where people marvel at how *anybody* could invest in the 1/3 or whatever of developed country govt bonds with negative (nominal ) yields...they don't think those negative yield opportunities in 'riskless' are pulling down risk premia in the global capital market at all?

And the market does not care a whit what I *want* as return. The fact that my 'risk profile' is the same or different is wholly irrelevant.

[alex_686]

Until someone can tell me why the risk premium is going to collapse, I just don’t buy that the future, in real terms, will be so consistently and dramatically different.

Well, for the past 40 years the Equity Risk Premium has been declining. So there is that.

I personally back the Secular Stagnation theory for future declines. There is a increase in savings for investments from demographics and increasing wealth inequities. There is a decline in investment opportunities. The new opportunities that are driving growth tend to not need much in the way of capital.

[Steve Reading]

Didn’t answer my question. Why has our risk profile dramatically changed?

I gave you two reasons (among many others) as to why you shouldn't expect the future to be like the past, which was your question. I'm not sure one of those reasons are "risk profile changes" like you do. How could I answer you why our risk profile has changed drastically when I'm not even sure it has? 0_o

If it hasn’t changed, then why would we accept lower returns for the same risk? Why wouldn’t we just invest in other instruments?

It's because everything is yielding less.

I expect equity returns going forward to be lower than in the past. But I expect the Equity Risk Premium (the excess risky return of stocks over cash) to be similar to the past. Population risk profiles affect the equity risk premium; how much return people demand for a certain amount of risk. But the baseline of what "no risk" yields has gone down and that has nothing to do with risk profiles.

I agree with your first point in most recent post and your two reason the future doesn't have to be like the past. In bonds this is obviously true. Is anyone really arguing that it's a fallacious 'this is time is different' argument to say you'll get 0.5% real pre-tax by investing in the 30 yr TIPS now when the past realized real pre tax return on long term bonds was 2-3% (something like that depends which bond investment exactly which period)? Yeah it *is* different now, the thing yields 0.5%. Running Firecalc on a 100% bond portfolio and saying 'no it gives me an average return of 2-3% or whatever not 0.5%, 0.5% is wrong!' is ridiculous.

I don't agree though the equity risk premium either needs to be as high as it used to be. If you think it is as an opinion that's fine, just saying it doesn't have to be. Spreads on credit risky bonds now are distinctly lower now than past historical (albeit not as long a history of apples-apples on bonds with significant credit spreads) and that's a somewhat similar risk. Again on your point of just looking at fundamentals in the world today and not having tunnel vision in the rear view mirror of past returns of a particular asset class, it's a pretty consistent scene of more capital chasing fewer opportunities for return and in efficient markets that would tend to mean lower risk premia as well as lower 'riskelss' return. Like in all the threads where people marvel at how *anybody* could invest in the 1/3 or whatever of developed country govt bonds with negative (nominal ) yields...they don't think those negative yield opportunities in 'riskless' are pulling down risk premia in the global capital market at all?

And the market does not care a whit what I *want* as return. The fact that my 'risk profile' is the same or different is wholly irrelevant.

Well if more capital is chasing fewer opportunities then, like you said, this drives down the return of both risk less and risky assets so theoretically the risk premium is preserved.

Idk, I couldn't tell you. I'm willing to bet equities will have a lower return than the past. I'm not very sure the equity risk premium will be noticeably different. Like you said, some risk less assets are already yielding negative nominal returns. And international stocks have valuations that hint at real returns well past 5%. That would be a sizable risk premium for instance. Idk it's hard to say IMO. My crystal ball gets cloudy when it comes to the premium for risk haha

[JackoC]

I don't agree though the equity risk premium either needs to be as high as it used to be. If you think it is as an opinion that's fine, just saying it doesn't have to be. Spreads on credit risky bonds now are distinctly lower now than past historical (albeit not as long a history of apples-apples on bonds with significant credit spreads) and that's a somewhat similar risk. Again on your point of just looking at fundamentals in the world today and not having tunnel vision in the rear view mirror of past returns of a particular asset class, it's a pretty consistent scene of more capital chasing fewer opportunities for return and in efficient markets that would tend to mean lower risk premia as well as lower 'riskelss' return. Like in all the threads where people marvel at how *anybody* could invest in the 1/3 or whatever of developed country govt bonds with negative (nominal ) yields...they don't think those negative yield opportunities in 'riskless' are pulling down risk premia in the global capital market at all?

Well if more capital is chasing fewer opportunities then, like you said, this drives down the return of both risk less and risky assets so theoretically the risk premium is preserved.

Idk, I couldn't tell you. I'm willing to bet equities will have a lower return than the past. I'm not very sure the equity risk premium will be noticeably different. Like you said, some risk less assets are already yielding negative nominal returns. And international stocks have valuations that hint at real returns well past 5%. That would be a sizable risk premium for instance. Idk it's hard to say IMO. My crystal ball gets cloudy when it comes to the premium for risk haha

Again I don't think there's any theory saying the risk premium is constant. You could argue that it is based on data people use to construct the ERP (there have been particular practitioners' work discussed on threads here, I think the optimistic ones are...optimistic in their inputs ).

You might say it's low riskless rates, low equity expected return, constant risk premium between them, and you could be right. But when I point to low return 'riskless' bonds, one of the factors there is central banks generating their own artificial demand to drive the yields down and therefore push private capital into equities to generate more demand via wealth effect of inflating equity values. Why would that not push down the ERP? And again consider lower credit spreads, noting that there are now some BB range, ie high grade junk, corp. issues in EUR with negative *nominal* yields, it's not only 'riskless' bonds with negative real yields. You're right some prognosticators (I linked Research Affiliates expected returns page above) say EAFE stocks are priced for 5+% real returns v 0.5% US large cap they project (if so a big ERP compared to avg DM, ex-US, real govt bond yields, true) yet in general I've found the consensus of this forum is not to believe that foreign stock expected returns are any higher than US if as high. I personally don't know. I think diversification rather than higher E[r] is the reason not to concentrate one's risk asset bets wholly in US stocks.

Anyway I agree ERP is an issue where it's relatively valid to leave it at, 'people disagree, and we really don't know'. But people who insist that the future distribution of absolute returns is the unconditional distribution of past returns are just being too optimistic I think. The distribution looking from now, conditional on now's low 'riskless' bonds and low stock earnings yields, has a significantly lower midpoint ('expectation') than historical.

On the positive side, it's arguable forward looking risk is also lower in a more transparent world. This was referred to in an earlier post. The more credible we find the statement 'history has shown us that stocks always do OK in the long run', the less of an ERP we deserve. Although if you look beyond the US it's more doubtful that history says stocks always do OK eventually. They didn't in the losers of the WW's or related post war upheavals (China 1949, etc.). Which gets back to how little independent data there is for long periods in the US. 1929-now is only three *independent* trials of 30 yrs, where the first included the dice coming up 'Depression doesn't cause a social meltdown' plus 'US wins WWII essentially unharmed'. It could have come up otherwise on either count. And for example the dice 'will economic growth be greatly curtailed on purpose for environmental reasons?', wasn't thrown in those three trials, but now it's going to be, among others not previously thrown. So I don't personally assume risk has decreased, doesn't mean expected return hasn't. And again the market doesn't care it we complain it's offering a worse deal now than it used to, tough luck says the market.

[Steve Reading]

. But when I point to low return 'riskless' bonds, one of the factors there is central banks generating their own artificial demand to drive the yields down and therefore push private capital into equities to generate more demand via wealth effect of inflating equity values. Why would that not push down the ERP?

I don't know how it would push down the ERP haha.

Say bonds yield 0% and stocks yield 4%. Then the banks artificially drive down bond yields to -1%. Everyone will now say "wait, I now get an additional 1% return with stocks over bonds, for the same risk as before? Yes please!".
And they buy stocks, driving up stock price and driving down it's yield. How low will the yield be driven? I argue it'll be driven down to around 3% since that was the equilibrium "I'll take stock risk for a 4% additional return" that existed in people's risk desires before the central bank took action.

You're saying a 1% drop in riskless assets will generate MORE than a 1% drop in stock expected returns, hereby reducing the ERP? So it follows that if the bond yield is low enough, the ERP is eventually zero ?

[alex_686]

. But when I point to low return 'riskless' bonds, one of the factors there is central banks generating their own artificial demand to drive the yields down and therefore push private capital into equities to generate more demand via wealth effect of inflating equity values. Why would that not push down the ERP?

I don't know how it would push down the ERP haha.

Say bonds yield 0% and stocks yield 4%. Then the banks artificially drive down bond yields to -1%. Everyone will now say "wait, I now get an additional 1% return with stocks over bonds, for the same risk as before? Yes please!".
And they buy stocks, driving up stock price and driving down it's yield. How low will the yield be driven? I argue it'll be driven down to around 3% since that was the equilibrium "I'll take stock risk for a 4% additional return" that existed in people's risk desires before the central bank took action.

You're saying a 1% drop in riskless assets will generate MORE than a 1% drop in stock expected returns, hereby reducing the ERP? So it follows that if the bond yield is low enough, the ERP is eventually zero ?

305pelusa has the crux of it. Not sure if I would agree with the ratios - things are a bit more fluid. That being said, if earnings remain constant, money floods into equities, it will push ERP down. If people are willing to accept higher risk or accept lower earnings, the ERP goes down. Here are 2 anecdotal accounts of private equity shoving money at people because they can't figure out anything conventional to do with it.

https://www.npr.org/2019/10/04/76737935 ... orn-cowboy
https://www.npr.org/2019/06/28/73710234 ... al-economy

[JackoC]

. But when I point to low return 'riskless' bonds, one of the factors there is central banks generating their own artificial demand to drive the yields down and therefore push private capital into equities to generate more demand via wealth effect of inflating equity values. Why would that not push down the ERP?

I don't know how it would push down the ERP haha.

Say bonds yield 0% and stocks yield 4%. Then the banks artificially drive down bond yields to -1%. Everyone will now say "wait, I now get an additional 1% return with stocks over bonds, for the same risk as before? Yes please!".
And they buy stocks, driving up stock price and driving down it's yield. How low will the yield be driven? I argue it'll be driven down to around 3% since that was the equilibrium "I'll take stock risk for a 4% additional return" that existed in people's risk desires before the central bank took action.

You're saying a 1% drop in riskless assets will generate MORE than a 1% drop in stock expected returns, hereby reducing the ERP? So it follows that if the bond yield is low enough, the ERP is eventually zero ?

Yes, risk premia could be compressed by central banks deliberately lowering 'riskless' returns (though reductio ad absurdum argument about zero risk premium are not relevant) because of an investor behavior factor that's obvious in every thread like this: investors are 'anchored' to ideas of what is an acceptable absolute return. IOW past returns definitely affects investor behavior even if such investors are misguided to believe that future returns will be like past returns. Without that fact, obvious as it to me at least, your argument would be stronger. As it is if 'riskless' rates are driven down as central banks become bigger owners of that asset class, private investors may tend to view the previous ERP as relatively more attractive as absolute yields decline, because they are also partly seeking a minimum 'deserved' absolute return. Therefore they'll buy up more of what they see as relatively attractive, and drive up its *relative* price, ie drive down the ERP. How much depends on elasticity, an empirical question. But again it seems in case of risky bonds/loans that lower absolute bond yields have been accompanied by a compression in credit spreads. There's no 'theoretical' reason this isn't also true of the ERP, no theoretical principal by which the market return on a given amount of risk has to be a constant over time. Efficient market theory only says the return on a given amount of risk has to be the same for different assets at the same time (which is also a reason to doubt that credit spreads tell us nothing about the ERP). And if the market perceives less future risk in risky assets than historically was the case, that would also cause risk premia to compress. And that's also anecdotally supported by common individual investor attitudes on this forum: 'stocks will always do OK in the long run' IOW stock risk isn't entirely real, but just 'a bumpy ride sometimes'. If that's really true it makes sense to accept less risk compensation than previous generations of investors perhaps more likely to have viewed stock risk in terms of countries where stock markets went to zero. Nothing says the collective market risk aversion must be constant and the ERP is in part a function of that.

[Steve Reading]

. But when I point to low return 'riskless' bonds, one of the factors there is central banks generating their own artificial demand to drive the yields down and therefore push private capital into equities to generate more demand via wealth effect of inflating equity values. Why would that not push down the ERP?

I don't know how it would push down the ERP haha.

Say bonds yield 0% and stocks yield 4%. Then the banks artificially drive down bond yields to -1%. Everyone will now say "wait, I now get an additional 1% return with stocks over bonds, for the same risk as before? Yes please!".
And they buy stocks, driving up stock price and driving down it's yield. How low will the yield be driven? I argue it'll be driven down to around 3% since that was the equilibrium "I'll take stock risk for a 4% additional return" that existed in people's risk desires before the central bank took action.

You're saying a 1% drop in riskless assets will generate MORE than a 1% drop in stock expected returns, hereby reducing the ERP? So it follows that if the bond yield is low enough, the ERP is eventually zero ?

Yes, risk premia could be compressed by central banks deliberately lowering 'riskless' returns (though reductio ad absurdum argument about zero risk premium are not relevant) because of an investor behavior factor that's obvious in every thread like this: investors are 'anchored' to ideas of what is an acceptable absolute return. IOW past returns definitely affects investor behavior even if such investors are misguided to believe that future returns will be like past returns. Without that fact, obvious as it to me at least, your argument would be stronger. As it is if 'riskless' rates are driven down as central banks become bigger owners of that asset class, private investors may tend to view the previous ERP as relatively more attractive as absolute yields decline, because they are also partly seeking a minimum 'deserved' absolute return. Therefore they'll buy up more of what they see as relatively attractive, and drive up its *relative* price, ie drive down the ERP. How much depends on elasticity, an empirical question. But again it seems in case of risky bonds/loans that lower absolute bond yields have been accompanied by a compression in credit spreads. There's no 'theoretical' reason this isn't also true of the ERP, no theoretical principal by which the market return on a given amount of risk has to be a constant over time. Efficient market theory only says the return on a given amount of risk has to be the same for different assets at the same time (which is also a reason to doubt that credit spreads tell us nothing about the ERP). And if the market perceives less future risk in risky assets than historically was the case, that would also cause risk premia to compress. And that's also anecdotally supported by common individual investor attitudes on this forum: 'stocks will always do OK in the long run' IOW stock risk isn't entirely real, but just 'a bumpy ride sometimes'. If that's really true it makes sense to accept less risk compensation than previous generations of investors perhaps more likely to have viewed stock risk in terms of countries where stock markets went to zero. Nothing says the collective market risk aversion must be constant and the ERP is in part a function of that.

Look what you say sounds right. There's logic to it, sure. But it's all conjecture. I can also make arguments for why the ERP would go up as riskless yield goes down:

As central banks drive rates down, the crowd sees what amazing return these assets have given (recency bias). They expect these yields to keep going down due to artificial banking policy. So they shy away from risky assets and buy the riskless bonds that keep going up as rates go down. And as they buy more of the them, the yield keeps going down and the price up, making a self-sustaining bubble which makes the ERP skyrocket.

^That also has logic to it based on investor irrationality. But it's pure conjecture too.

Bottomline: I don't think the ERP must be constant. It is NOT. We have time periods (decades long) when the ERP is greater than 5%, and decades when it's negative. It has fluctuations. But I'm not sure the average, underlying ERP necessarily changes that much based on the riskless yield. And I need to see many decades of a lower ERP before I'd concede that the ERP has truly gone down in humanity versus simply being depressed like it has countless times in the past.
That's really all I can say on the matter.

[gmaynardkrebs]

While I agree about ERP compression as a factor in today's seemingly high valuations, that doesn't rule out a bubble.

[dharrythomas]

My problem is that I just don’t know and I don’t have a better idea than equity investing in a balanced global portfolio, so I am stuck.

I expect US equity returns to be lower going forward than the historic average, because interest rates cannot continue to provide the tailwind they have since the early 1980s and by most measures US equity values are at least fully valued.

I expect international equities to return more than US equities.

Bonds are a problem in a rising interest rate world and if interest rates don’t rise don’t return enough to be interesting.

The model of a healthy world I hold in my head requires interest rates to be higher than today. Negative interest rates don’t work in many models and drive investment in lower returning projects and push investment out the risk curve in the pursuit of yield, historically those things have not ended well. Even without the current geopolitical risks and retreat from globalism.

In the short term I have no idea, over the next decade 1-2% is probably in the middle of the range of reasonable expectations. That would probably set up subsequent decades for a more normal equity return. There is pain in working the excesses out of the system.

Good luck.

[nedsaid]

I don't see compelling evidence that we should expect lower real returns than the norm. All such low return predictions are every bit as speculative as the high return predictions of the late 90s.

Yep. What happens if stocks really aren't as expensive as we think? The gap between book value the value of a company measured by the accountants and market value as determined by the stock market seems to be growing. Some reasons for this as has been covered in other threads. It seems that companies are increasing in value faster than earnings increase, it makes you wonder if something is wrong with the benchmarks, the measuring sticks. Are earnings understated?

[HomerJ]

I'm loving all the people banging on about chi squared tests and how 'CAPE is unimportant'



It looks like a fairly useful correlation to me...

Why don't you actually look at the numbers on that chart.

Look at 1929 or the entire 1960s... CAPE was above 20, real returns were 0% or negative.

Now look at all the years past 1992, when CAPE crossed 20 and basically stayed above 20 for the past 27 years (except for brief dip in 2009).

CAPE has been ridiculously high for 27 years. And yet 15-year returns are shown to have been in the 3%-9% real range (historical average is 7%). 10-year returns have been even better (I'm wondering why 15-year returns were chosen for this chart).

CAPE has not done a good job predicting returns since it was discovered.

All the data points before 1988 were used to DERIVE the model. Right after CAPE was formulated, it went to a very high historical level, and basically has stayed there ever since (yet returns have stayed around the historical average).

Anyone actually watching CAPE seriously would have gotten out of the market in 1992, expecting 0% or 1% real, and missed out on the entire 90s bull market.

It's failed as a market-timing tool. And it doesn't seem to model reality very well anymore...

Here's a good article on it...

http://www.philosophicaleconomics.com/2013/12/shiller/

For most of history, the Shiller Cyclically-Adjusted Price-Earnings ratio (CAPE) oscillated in a pseudo sine wave around a long-term (130 year) average of 15.30. It spent 55% percent of the time above the average, and 45% of the time below–a reasonable result for a metric that allegedly mean reverts. Since 1990, however, the metric has only spent 2% of the time below its historical average–98% of the time above. (Note - this was written in 2013 - it's 99% now)

The metric’s failure to mean-revert over the last 23 years hasn’t been for a lack of reasons. The period covered three recessions, two stock market crashes, and one bonafide financial panic–the likes of which hadn’t been seen since the Great Depression. Even in the worst parts of the 2008-2009 crash–at levels that we now look back on with nostalgia as the “buying opportunity” of our generation–the metric failed to provide an accurate valuation signal. In an inexcusable blunder, it basically called the market “slightly below fair value”.

If we’re being honest, there are only two possibilities. Either the “normal” levels of the metric have shifted significantly upwards over the last few decades, or the metric is broken. There is no other way to coherently explain why the metric has consistently failed to migrate towards its long-term average, or spend any amount of time below it, as it should do every so often in bear markets.