A Sobering Investment Outlook

From the ever perceptive John Authers of the FT

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oth equities and bonds look expensive compared with their own history (dramatically so in the case of bonds). Put the two together and the plight of pension funds with fixed liabilities to meet appears impossible. Cliff Asness, a former academic who now runs AQR Capital Management in New York, says the prospective return over the next decade from a portfolio invested 60 per cent in US equities and 40 per cent in bonds is 2.4 per cent per year. This is the worst predicted return in 112 years.

An alternative forecast by Elroy Dimson, Paul Marsh and Mike Staunton, financial historians at the London Business School, points to the extreme low real interest rates and shows that these have been associated over history with low subsequent returns for both equities and stocks.

They suggest that the returns in the late 20th century were driven by unrepeatable positive factors such as the postwar booms in Germany and Japan, and the fall of the iron curtain. Now, global demographics give institutions no room for manoeuvre. As the “baby boom” cohort retires, the balance shifts from those contributing to pensions to those receiving payouts.....

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long cycles of “bull” and “bear” markets are defined by how expensive stocks are at the outset. In a bear market, valuations steadily become cheaper until stocks are unambiguously attractive once more.

The commodities supercycle is over. But we can’t yet say we’ve entered a new secular bull market in equities

How to measure cheapness? Cyclically adjusted price/earnings (Cape) multiples, where share prices are compared with average earnings over the previous 10 years to account for changes in the business cycle, have been a good guide to long-run returns.

In 2000, when the bear market first broke out, the Cape on the S&P stood at 44, by far the highest in history. Even the Great Crash in 1929, which was followed by the Great Recession and a savage bear market, began with a Cape of only 32.5.

Now Cape stands at 23.5 – far above its historical average, although not at an extreme. Historically, as the chart shows, investors can expect equities to gain less than 1 per cent in a decade if they start with Cape at this kind of level. Generally, bull markets only start when it has hit single figures.

Ed Easterling, an expert in secular market trends at Crestmont Research in Oregon, says: “In 1996, we got to the normal high but then went into bubble mode. We’ve spent the last 13 years going from the bubble zone to the overpriced zone. We can’t start a secular bull market from here because we don’t have valuation levels low enough to give us above-average returns in future.”