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3 Things: Expected Returns, Returns, & Net Returns
Submitted by Lance Roberts via STA Wealth Management,
What Drives Returns
John Coumarianos, via MarketWatch, penned a very interesting note recently with respect to the view that it is just "volatility" is driving prices.
"The great economist John Maynard Keynes once said: 'Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.'
Few recent writings display this phenomenon better than a blog post by Josh Brown, aka The Reformed Broker, the title of his well-read (usually deservedly so) website.
Brown's post, cleverly titled "Why the stock market has to go down," incorrectly asserts that volatility is ultimately what rewards stock investors who have the ability to withstand it.
This is the standard talk that most advisers give their clients. It comes from the academic 'efficient markets' or 'random walk' school of thought. And it is totally wrong.
The truth is that the stock market doesn't owe you anything, no matter how volatile it is and no matter how long you wait."
This is absolutely true. What drives stock prices (long-term) is the value of what you pay today for a future share of the company's earnings in the future. Simply put - "it's valuation, stupid." As John aptly points out:
"Stocks are not magical pieces of paper that automatically deliver gut-wrenching volatility over the short run and superior returns over the long run. In fact, we've just had a six-year period with 15%-plus annualized returns and little volatility, but also a 15-year period of lousy (less than 5% annualized) returns.
It's not just volatility; it's valuation.
Instead of magical lottery tickets that automatically and necessarily reward those who wait, stocks are ownership units of businesses. That's banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure."
"And stocks are not so efficiently priced that they are always poised to deliver satisfying returns even over a decade or more, as we've just witnessed for 15 years. A glance at future 10-year real returns based on the starting Shiller PE (price relative to past 10 years' average, inflation-adjusted earnings) in the chart above tells the story. Buying high locks in low returns and vice versa.
Generally, if you pay a lot for profits, you'll lock in lousy returns for a long time."
Volatility is simply the short-term dynamics of "fear" and "greed" at play. However, in the long-term as stated it is simply valuation. As I showed earlier this week in "4 Warnings And Why You Should Pay Attention" I discussed valuation specifically stating:
"Valuations are a very poor market timing device for short-term investors. However, from a long-term investment perspective, valuations mean a great deal as it relates to expected returns. Chris Brightman at Research Affiliates recently noted this exact point.
'As a long-term investor, we experience short-term price volatility as opportunity, and high prices as risk.'
With earnings growth deteriorating, and valuation expansion having ceased, the risk of high-prices has risen sharply."
Nothing But "Net"
One of the biggest myths perpetrated by Wall Street on investors is showing individuals the following chart and telling them over the "long-term" the stock market has generated a 10% annualized total return.
The statement is not entirely false. Since 1900, stock market appreciation plus dividends have provided investors with an AVERAGE return of 10% per year. Historically, 4%, or 40% of the total return, came from dividends alone. The other 60% came from capital appreciation that averaged 6% and equated to the long-term growth rate of the economy.
However, there are several fallacies with the notion that the markets long-term will compound 10% annually.
1) The market does not return 10% every year. There are many years where market returns have been sharply higher and significantly lower.
2) The analysis does not include the real world effects of inflation, taxes, fees and other expenses that subtract from total returns over the long-term.
3) You don't have 145 years to invest and save.
The chart below shows what happens to a $1000 investment from 1871 to present including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio. In reality, all of these assumptions are quite likely on the low side.)
As you can see, there is a dramatic difference in outcomes over the long-term.
From 1871 to present the total nominal return was 9.07% versus just 6.86% on a "real" basis. While the percentages may not seem like much, over such a long period the ending value of the original $1000 investment was lower by an astounding $260 million dollars.
Importantly, the return that investors receive from the financial markets is more dependent on "WHEN" you begin investing as noted above.
Too Optimistic
Following on with the point above, with valuations currently at the second highest level on record, forward returns are very likely going to be substantially lower for an extended period. Yet, listen to the media, and the majority of the bullish analysts, and they are still suggesting that markets should compound at 8% annually going forward as recently stated by BofA:
"Based on current valuations, a regression analysis suggests compounded annual returns of 8% over the next 10 years with a 90% confidence interval of 4-12% (Table 2). While this is below the average returns of 10% over the last 50 years, asset allocation is a zero-sum game. Against a backdrop of slow growth and shrinking liquidity, 8% is compelling in our view. With a 2% dividend yield, we think the S&P 500 will reach 3500 over the next 10 years, implying annual price returns of 6% per year."
However, there are two main problems with that statement:
1) The Markets Have NEVER Returned 8-10% EVERY SINGLE Year.
Annualized rates of return and real rates of return are VASTLY different things. The destruction of capital during market downturns destroys years of previous capital appreciation. Furthermore, while the markets have indeed AVERAGED an 8% return over the last 115 years, you will NOT LIVE LONG ENOUGH to receive the same.
The chart below shows the real return of capital over time versus what was promised.
The shortfall in REAL returns is a very REAL PROBLEM for people planning their retirement.
2) Net, Net, Net Returns Are Even Worse
Okay, for a moment let's just assume the Wall Street "world of fantasy" actually does exist and you can somehow achieve a stagnant rate of return over the next 10-years.
As discussed above, the "other" problem with the analysis is that it excludes the effects of fees, taxes, and inflation. Here is another way to look at it. Let's start with the fantastical idea of 8% annualized rates of return.
8% - Inflation (historically 3%) - Taxes (roughly 1.5%) - Fees (avg. 1%) = 3.5%
Wait? What?
Hold on...it gets worse. Let's look forward rather than backward.
Let's assume that you started planning your retirement at the turn of the century (this gives us 15 years plus 15 years forward for a total of 30 years)
Based on current valuation levels future expected returns from stocks will be roughly 2% (which is what it has been for the last 15 years as well - which means the math works.)
Let's also assume that inflation remains constant at the current average of 1.5% and include taxes and fees.
2% - Inflation (1.5%) - Taxes (1.5%) - Fees (1%) = -2.0%
A negative rate of real NET, NET return over the next 15 years is a very real problem. If I just held cash, I would, in theory, be better off.
However, this is why capital preservation and portfolio management is so critically important going forward.
There is no doubt that another major market reversion is coming. The only question is the timing of such an event which will wipe out the majority of the gains accrued during the first half of the current full market cycle. Assuming that you agree with that statement, here is the question:
"If you were offered cash for your portfolio today, would you sell it?"
This is the "dilemma" that all investors face today - including me.
Just something to think about.
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Many people I know have definitely starting focusing on the return of their cash and captial...
I would sell my portfolio, though only for gold, silver, platinum, lead, food, land, dirt, last weeks newspaper or dog poop.
"The great economist John Maynard Keynes once said: 'Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.'
And yet here we are......
The problem is, if very high inflation is coming, is it worth it to sell your stocks? Think about it.
that's why the market becomes a pickers market, short and long, in a downturn. that's where the genius is. it is time to take the btfd geniuses out so says the fed.
Hmmm......fiat or mark to fantasy stocks..... I think i will take neither!
the buffet meausre tying equity value to 30 year bond value and anything over that gravy. simple is better.
Funny. or rather ironic. My colleague (still working) just sold his house in New Orleans for a cool 2.5 million. He's already well past retirement at age at 80. I told him "You've got a real "problem" now. What are you going to do with the money?"
When he had no answer, I reminded him, knowing that he had looked at places to retire inEurope from Lichtenstein to Germany (speaks fluent German) and bemoaned the chaos they had devolved in, plus the inability to shield his money from inflation, the strong possibility of a looming stock market crash, bond default / rise in interst rates/ rendering his savings worthless, the possibility of big tax liability if he bought land, etc, he finally admitted "What the hell am I going to do?"
There really is no place to hide.
Bullshit. Talk to any one of the Cayman banks...
PMs.
Club members hide their money just fine, have him go to an economics "summit" somewhere and get to know a few. He sounds like a successful person, even he, especially at 80, must be wise in the real ways of the world. Maybe talk to a politician get some cool "non-profit" going...
Hookers and blow...
Sorry, but he's a doctor. Not much sophistication.
Cayman Banks? Well, you are still in the paper money /fiat promise land. Just that. Only a promise. No way.
I mentioned at least 25% in physical PMs.
At least the 30 year is stable...that bastion of capitalism, that bulwark of money itself...that structure of the very money we hold...wha...off 3% in one day...My good man that is simply not possible. Get from my sight with your lies.
Should read> Guidance(a) x Non GAAP(b) = GAAP ZIRP (c)
after<>tax revenue= (abc) / <> (ab) -(c)guidance.
um, I am short. Very, very short.
Can you explain your offer to me a little more clearly?
A friend big in equities tells me he is sure a collapse is coming. "So sell, you are way ahead right now" was my response. "Oh, can't do that, the capital gains taxes would kill me" was his reply. He's locked up, either way will cost him.