As discussed in Part 1 of "Why Past Performance of a Conventional (60-40) Portfolio Is NOT Indicative of Future Performance", the results of a conventional 60-40 portfolio over the last 30 years aren’t likely to repeat in the near future.
Going forward, if the P/E ratio reverts to its long-term average of 16.4, corporate profits grow at their historical average of +4.70%, and dividends increase at the same rate as corporate profits (and the dividend payout ratio increases to its long-term average), stocks will appreciate at just 7.05% per year over the next decade. Here’s the arithmetic.
Future returns from U.S. equities
To determine the likely return for the S&P 500 over the remainder of this decade we need three primary inputs:
- The rate of earnings growth for the companies underlying the index,
- The most likely P/E ratio people will pay for those earnings at year-end 2020, and
- The dividend yield for those stocks during the period.
Let’s look at each of these in turn.
Return contribution from earnings growth
Since 1900, the nominal (before inflation) average annual growth rate for companies in the S&P 500 has been 4.7%. Over the same period the average annual inflation rate has been 3.04%. For purposes of our projections I will assume these two variables continue at the same rates into the future. While I understand there are many people who expect a substantial increase in inflation, historically, that has also resulted in an increase in the nominal (before inflation) return for the S&P 500. So if that were to occur, while the nominal return from the S&P 500 would likely increase, the real (after inflation) rate of return would, on average, remain around the historical level of 1.7%. Because of this, I project the annual return contribution from earnings growth, between 2012 and the end of 2020, will be +4.70%.
Return contribution from investor sentiment
There are a variety of methods used to calculate the price/earnings ratio of a stock or stock index. The method I will use in this article is CAPE (“Cyclically Adjusted Price Earnings Ratio”), the ratio popularized by Robert Shiller in his book Irrational Exuberance. CAPE compares the S&P 500’s current price to the 10-year average of earnings. This has the benefit of smoothing earnings volatility to reduce the short-term impact of events such as the 2008 financial crisis. Over the past 113 years, CAPE has ranged from a low of 4.46 (in the depths of the Great Depression) to a high of 48.94 (at the peak of “dot-com” hysteria in 1999). The average CAPE over that period has been 18.63.
As of year-end 2012 CAPE stood at 23.37. Part of the reason the rate was above the long-term average was because the 10-year average earnings value used in the calculation was depressed by the effects of the Great Recession of 2008. In order to make the CAPE value in 2020 appear less elevated (compared to the long-term average) than it appears today due to the Great Recession, I will continue to walk forward the earnings average of the prior 10 years from 2013 through 2020, assuming average earnings growth based on the long-term average of 4.7%. This results in a growth rate of 6.8% for the 10-year earnings average from 2013 through 2020.
As a result of the combination of the increase in the 10-year average of profit growth and CAPE reverting to its long-term average, I project the annual return contribution from investor sentiment, between 2012 and the end of 2020, will be 0.73%.
Return contribution from dividends
The dividend yield on the S&P 500 at year-end 2012 was approximately 2.20%. This represents a dividend payout ratio of 36%. This figure is quite a bit lower than the 113 year average of 59%. If the payout ratio reverts to its long-term average, this will boost the dividend yield over the remainder of this decade. As a result of this, and assuming that dividends grow at the same rate as profits, which is 4.7% per year, I project the annual return contribution from dividends, between 2012 and the end of 2020, will be +3.07%.
Calculating the S&P 500 total return
We’re now left with a simple arithmetic problem to determine the projected average annual return for the S&P total return index, between 2012 and the end of 2020.
This is the sum of the contribution from each of the three return drivers:
Earnings Growth: +4.70%
Investor Sentiment: - 0.72%
Dividends: +3.07%
Total: +7.05%
Future returns from bonds
For the past 31 years the Barclay Aggregate Bond Index averaged annualized returns of 8.43%. Unfortunately, the two primary return drivers that contributed to that performance are both destined to provide much lower returns in the future. They are:
- The capital appreciation provided as the high interest rate of 13% that prevailed at the start of the period declined to just over 1% today, and
- The average yield of 5.74% on the 5-year Treasury note over the period.
With the Barclay Aggregate Bond Index now yielding just over 2%, and the U.S. Treasury 5-year note yielding 1.05%, the likely return from bonds over the remainder of this decade should be similar to the current yield on the Barclay Aggregate Bond Index, which, as represented by the iShares ETF (AGG) is 2.43%.
Calculating the return on the 60-40 portfolio
In summary then, based on the above straightforward analysis, from year-end 2012 through year-end 2020 we can expect the following return from a conventional 60-40 portfolio:
This is less than 1/2 the return earned over the past 31 years and approximately 1/3 the returns produced since the Great Recession low in March 2009. As I pointed out at the beginning of this article, 60-40 has always been a risky proposition; returns are earned in a “lumpy” fashion. Without the tailwinds of low P/E, high dividend yield and high interest rates, in the future those lumpy returns will be earned in relation to a lower trendline of overall performance. Also, while these projections are based on a sound analysis of the return drivers powering the 60-40 portfolio’s performance, they are certainly not absolute. Already, in the first 5 months of the 8-year projection period (January 2013 through December 2020), the 60-40 portfolio has gained more than 5%, twice that expected from these projections.
Portfolio diversification is the one true “free lunch” of investing, where you can achieve both greater returns and less risk. But, as can be seen by its reliance on just four return drivers, the conventional 60-40 portfolio does not provide true portfolio diversification. When those four return drivers underperform, as is indicated by the projections in this article, performance will suffer. True portfolio diversification can only be obtained by increasing diversification across dozens of return drivers. I give examples of a truly diversified portfolio in the final chapter of my book, and am pleased to provide a complimentary link to that chapter here: Myth 20. While some people may prefer to gamble on a less-diversified 60-40 portfolio, as my book shows, in the longer-term, true portfolio diversification can lead to both increased returns and reduced risk.
About the Author:
Michael Dever is the CEO and Director of Research for Brandywine Asset Management, an investment firm he founded in 1982. He has been a professional investor/trader since 1979 and has experience in stocks, managed futures, commodities, mutual fund timing, market neutral equity, and long/short equity. He is also the author of “Jackass Investing: Don’t do it. Profit from it.”, an Amazon Kindle #1 best-seller in the following “investment” categories: Commodities, Futures, and Mutual Funds.
