There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.In other words, trying to call the stock market in the short term is very hard work, but calling it long term is relatively easy. However, there is a right way and a wrong way to forecast long run equity market returns.
The wrong way
Robert Shiller is well-known for his analysis showing that long-term stock real returns, i.e. after inflation, to be 7%. With CPI at 1.5%, the long term stock returns should be 8.5%, right?
There are a number of problems with that approach. First of all, will you live long enough or be patient enough to see those kinds of returns? The long-term chart below shows periods when the stock market has been in multi-decade range-bound episodes. If you are in one of those periods, your returns may be subpar for a very long, long time. Can you be that patient?
Dow Jones Industrials Average (from 1900)
Lancer Roberts, writing at Pragmatic Capitalism, made the same point. Stock returns depend on when you start. As the chart below shows, there are wild variations in equity price returns, though an upward long term trend is discernible.
Here is Roberts' analysis of 40-year stock returns by starting decade. Do you want to roll the dice on what you get?
The bluest of the blue chips was the British bond market. Other developed markets included France and Germany. Oh, yeah, don't forget the Austro-Hungarian Empire. If you wanted to take more risk, you could have looked at emerging markets such as Russia, the US, Canada, Argentina and Japan.
Fast forward 113 years, how did that portfolio work out? Now you understand what I mean by survivorship bias. Global Financial Data went all the way back to 1800 and reported the instances of government bond defaults:
1. Germany 1938,1948The point I am trying to make here is we have no idea who the winners and losers will be in the future, so if you step back in time and only considered the returns of the winner (US equities) in your study, you will have overstated returns by a huge margin.
2. Japan 1942, 1946-1952
3. France 8 times between 1558-1788. Last one in 1812
4. Italy 1940. Almost daily speculation of another default since 2008
5. Spain 1809, 1820, 1931, 1834, 1851, 1867, 1872, 1882 and 1936-1939. Since 2008, Spanish yields spiked considerably and have been volatile on the back of another default
6. Austria 1938, 1940, 1945
7. United Kingdom 1822, 1834, 1888, 1932
How much would Dracula be worth?
Think about it this way, let's take Robert Shiller's assertion that equity real returns of 7% to be correct. Supposing that a hypothetical immortal like Count Dracula (hey, vampires are rich - they have castles and other stuff, right?) invested $10,000 into the stock market 500 years ago. Assuming 3% inflation over the 500 years, Dracula's wealth he would have today would have 24 zeros after it. Is that plausible?
To put the problem of estimating long term equity returns into perspective, Morningstar broke down risk into three categories:
- Destruction: The reason why Dracula might not be a super-tycoon is that in the last 500 years, a lot of empires went down and a lot of people got killed in some very nasty ways. Wealth was destroyed during those episodes.
- Volatility: This is the "conventional" risk that most academics focus on, but it's not the only source of risk.
- Uncertainty:: Uncertainty can be best described as the risk of fraud or poor governance. Morningstar described it as: "The simplest species of uncertainty is not knowing when writing a check whether the other party is a crook."
In summary, using these very long term estimates of equity returns are problematical at many levels. Even if we were to assume away the risks of destruction and uncertainty, there are huge variations in stock returns and you may not live long enough to see the 7% real return postulated by Shiller.
A more realistic approach
I prefer a more realistic approach. Instead of using multi-decade long time horizons, a more realistic forecast horizon is 3-7 years. As the Royal Swedish Academy of Sciences noted, "It is quite possible to foresee the broad course of [stock] prices over longer periods, such as the next three to five years."
My principal approach to 3-7 year equity return forecast is based on two elements, valuation and demographics. In the short run, valuation doesn't matter much to the direction of stock prices. In the 3-7 year time frame, valuations matter a lot. The simplest way to forecast prices is to watch stock market.valuation.
The long-term chart of the Dow at the beginning of this post shows that the stock market has moved to new all-time highs, indicating that equities may have broken out of a range-bound period. I am skeptical of that view because of valuations. Consider this chart of market cap to GDP that goes back to 1927 as a proxy for price to sales for the US stock market. Does this look cheap to you? Past secular bulls have not begun with valuations at such elevated levels.
Ed Easterling analyzed historical P/E ratios and concluded that the current secular bear market, which has been associated with range-bound markets, has only just begun. He charted the normalized P/E ratio progression of secular bulls, where stocks have gone to multi-year and multi-decade new highs:
...and he did the same for the secular bears where the market stayed range-bound. The current bear, shown in dark blue, began at stratospheric normalized P/E levels and the normalized P/Es have only descended to readings that can be best described as elevated:
What are smart investors doing?
If you don't want to do the work to judge whether the stock market is over or undervalued based on P/E and other valuation measures, one simple way is to watch what smart investors are doing. Here, the signals for long term returns are ominous.
Consider the Bloomberg report that private equity funds are selling via the IPO process:
Private-equity managers from Fortress Investment Group LLC (FIG) to Blackstone Group LP (BX), which made billions by buying low and selling high, say now is the time to exit investments as stocks rally and interest rates start to rise...
“It’s almost biblical: there is a time to reap and there’s a time to sow,” Apollo’s Black said at a conference in April. “We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down in our portfolio.”
Black’s New York-based firm, which oversees assets worth $114 billion, generated $14 billion in proceeds from the sale of holdings between the first quarter of 2012 and the first quarter this year.Simply put, they can't find anything to buy [emphasis added]:
The industry’s focus on exits has reduced volumes of leveraged buyouts this year, with the number of private-equity deals announced declining 20 percent to 3,047 worldwide from the same period last year, according to data compiled by Bloomberg.As well, legendary investors like Warren Buffett, Stan Druckenmiller and Carl Icahn have recently come out with cautious statements on the stock market (via Business Insider). Buffett echoed the views of private equity investors that he can't find much value in the market. However, he did allow that the underlying businesses of Berkshire Hathaway was doing well:
“It’s a difficult environment to find really attractive things when the markets are robust as they are,” Fortress’s Edens said yesterday.
[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.Stan Druckenmiller believes that stock prices are artificially buoyed by Fed policy. He has no idea of when this stops, but such a few does not bode well for long-term stock returns:
Druckemiller elaborated “My first mentor and boss, Dr. Ellis in Pittsburgh, used to tell me it takes hundreds of millions of dollars to manipulate a stock up, but the minute you have this phony buying stop, it can go down on no volume and it can just reprice immediately. I personally think as long as this game goes on, assets will stay elevated. But when you remove that prop - and let's face it, the Fed has said they're targeting those asset prices - those prices can adjust immediately.”One common thread of these smart investors is that their belief that stock prices are fairly or over-valued, but there is no imminent risk that the market goes over a cliff.
Demographics is destiny
Another way of forecasting stock prices is to study the demographics of equity supply and demand. I have written about the demographics issue before (see Demographics and stock returns and A stock market bottom at the end of this decade). For stocks to go up, there has to be more buyers than sellers at a given price. The propensity of Baby Boomers, as they move into retirement, is to take money out of stocks. In order for equities to rise, those negative fund flows have to be met by the retirement savings of their children, the Echo Boomers. Two research groups looked into this topic (see papers here and here). Their conclusion - the inflection point at which the fund flows of Echo Boomers moving into stocks start to overwhelm the Baby Boomers taking money out is somewhere between 2017 and 2021.
Niels Jensen at Pragmatic Capitalism summarized the issues much better than I ever could:
Given the large number of boomers knocking on the 70+ door, these findings should not be ignored. In another study from 2012, McKinsey Global Institute found that U.S. households reduce their exposure to equities in a meaningful way as they grow older, supporting Arnott’s and Chaves’ conclusion that large cohorts of 70+ year olds is bad news for equity returns (chart 3). We know that U.S. baby boomers own 60% of the nation’s wealth and account for 40% of its consumer spending, so their effect on the economy and financial markets shouldn’t come as a surprise.
US household asset allocation by cohort
Jensen pointed to the San Francisco Fed paper that suggested a stock market bottom in 2021:
The most likely stock market trajectory
Putting the valuation and demographics forecasts together, the 3-7 year equity market forecast is for further subdued returns. Under these circumstances, the GMO forecast -2% real return for large cap US equities appears to be in the right ballpark:
I am also in the same camp as John Hussman in his long-term return forecast:
However, the comments from Buffett et al are also revealing. While equity valuations appear to be elevated, there is underlying momentum in Berkshire's businesses so there doesn't seem to be any imminent risk of a bear market.
So should you be bullish or bearish? That depends on your time horizon. The best perspective is one chart produced by Steve Suttmeier of BoAML. The firm's official view is that the major stock averages have convincingly broken out to new highs and we are seeing the start of a new secular bull. However, Suttmeier found parallels between the current range-bound market with the 1966-1982 period and did allow for a final bearish relapse before the market blasts off to new highs as they did in the mid-1980's.
In summary, I remain long term cautious on equity returns. It seems that with the market trading at such lofty multiples, we only need to see a negative catalyst to send stock prices tumbling. By their very nature, negative catalysts are unpredictable and can come out of left field. As I have pointed out before (see The sun will come out tomorrow), I am therefore watching the following three tripwires on a tactical basis for a bearish signal:
- Signs of economic slowdown
- Monetary policy
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.