Financial Planning . Investment
Management . Fiduciary . Independent . Fee-Only
Market Update - July
In this Market Update, we
will focus on three issues – economic conditions today, expected future
investment returns, and the new financial deregulatory policies of the Trump
During the first half of
2017, equity markets around the world continued to post strong gains while
returns to fixed-income investments were respectable. In sum:
US stocks rose 9.3%.
stocks posted gains of 14.6%.
Global stocks, in
total, gained 11.4%.
Large cap stocks
beat small cap stocks by 3%.
Growth stocks led
value by 9%.
bonds returned 2.3%.
Inflation was at
US economic growth in the
first half of 2017 continued at a modest pace.
Department reported that the economy grew at a rate of just under 2 percent for
the first half of the year.
More of the same for the coming years is the predominant
professional forecast. The Trump Administration is planning for 3% growth.
Other economic indicators, such as the stock market, unemployment, wages, home
prices and corporate profits, all seem to indicate steady economic progress.
Inflation is low and stable. The US economy is now in one of its longest
While the economy
seems to be in a sweet spot, there is risk of investor complacency during such
periods. Indeed, the options market is signaling very low risk aversion. And
there is no obvious reason the stock market is hitting such relative valuation
heights, let alone index record closes, now with such frequency. Many reasons
have been advanced, but uncertainty reigns. It may be the market still expects
great things from the new political order in Washington, such as tax reform,
deregulation, a repeal of Obamacare, and a major spending package. Meanwhile,
quantitative easing (the Fed expanding the money supply) and historically low
interest rates could be inflating the value of the stock market. Or, possibly
it is part momentum fueled by overconfidence reflecting a stock market that
during the past eight years has more than tripled in value and has seen average
annual returns of 18%, notwithstanding that the market declined 50% in value
during the 2007-2009 Financial Crisis.
Meeting this June,
the Fed raised its benchmark interest rate for the third time recently to a
range of 1 percent to 1.25 percent. The Fed also described its plans for
reducing its bond holdings, which may begin later this year, and expectations
for gradual interest rate increases totaling about 2% over the next 2-3 years.
These Fed policies likely would incrementally dampen investor enthusiasm for
stocks and bonds
returns have been generous of late, and particularly since the end of the
financial crisis and the Fed flooding the economy with cash, what should we
expect going forward? For present purposes, let’s just focus generically on
bonds and stocks.
On the high-grade
bond side of the investment world today, an asset class that is a staple of
portfolios, yields as far out as 30 years top-out in the 3% range. This is
historically very low; the norm has been about 6%. It is anticipated that rates
will be “normalized” over the next few years, but the new normal interest rates
will be lower than before. The normalization of rates will depress the prices
of existing bonds to varying degrees.
differently than bonds and expected returns are much more difficult to
estimate. Let’s look at one of the most respected stock valuation indicators,
the Shiller CAPE ratio, to see what it implies. The CAPE (cyclically adjusted
price-earnings) ratio is calculated by dividing the current US stock market
value by the inflation-adjusted 10-year average of the stock market’s earnings.
Think of the CAPE as being analogous to an interest rate for stocks which is
inverted, so a lower value means buying more cheaply expected future stock
titled CAPE Price E10 Ratio, shows the current CAPE value for the US large cap
stock market at 30.49. That is about twice the CAPE historic average value and
implies that stock rates-of-return going forward (because the current prices are
so relatively high) will be much lower than historic average returns.
Previously, only the years around 1929 and 2000 saw such elevated CAPE values;
severe market crashes followed both those eras, but not immediately. For
example, the CAPE continued to increase another 3 years from 1997 until, when in
2000 the market crashed, the CAPE reached the peak of 44. The market had gained
another 64% in value during that period.
Today, of note, we do not
see relatively inflated CAPE valuations in foreign stocks, which seem to be
An elevated CAPE ratio such
as we currently are experiencing does not definitively indicate anything
specific about the future; stock markets are too uncertain for such precision.
But CAPE values do seem to be meaningfully and inversely correlated with
future market returns. Here, we can explore what the current CAPE ratio may
suggest about the future by looking at real examples from the recent past.
To illustrate a relationship
of CAPE to future stock market returns, two charts are shown which compare stock
market returns and CAPE over two rolling time periods, 20 years, and 17 years.
These rolling time periods are used because they permit the inclusion of CAPE
values as high as they are today (1997) and the historic peak of CAPE (2000);
therefore, we can examine actual cases of very long-term stock market returns
that followed periods beginning with CAPE values comparable to today.
The two lines in the graphs,
showing stock market returns and CAPE values, use different axes:
The horizontal axis
Dates correspond to the
value at the end of the
rolling time-period for the stock market average annual return.
Dates correspond to
the value at the beginning of the rolling time-period for CAPE.
The vertical axes
On the left, scale
shows values for the stock market average annual return.
On the right, scale
shows values for CAPE. Note the CAPE axis is inverted, which is done to
better illustrate visually the relationship between the two lines.
shows rolling 20-year average annual returns for stocks in comparison to the
value of CAPE at the beginning of each 20-year period. The correlation of the
two lines is very high; that suggests that future long-term stock market
investment returns (solid line) may be highly sensitive to (or otherwise
connected to) the initial value of CAPE (dotted line). For example, about 20
years ago in 1997 the CAPE was, as today, at about 30. What did the market
return over the next 20-year period? The average yearly return for over 20
years (1997-July 2017) was about 6.5%, which is about 4.5% annually less than
“average” historic stock market returns (about 11%).
It is instructive also to
look at the chart data corresponding to the beginning of the 1997-2017 period
from a more intuitive perspective. At the start of the period, an investor
looking at the then previous 20-year returns in the stock market saw an average
annual return of about 14%! And many investors then assumed the long-term
future returns would be similar. If a retirement plan, or a pension plan, had
been built assuming a continuation of such stock market returns, the difference
between the 14% target and the actual 6.5% could have seriously derailed the
plan. For example, over 20 years $100,000 invested at 14% earns $1,274,000, at
11% earns $806,000, but at 6.5% earns only $252,000.
The third chart
shows rolling 17-year average annual returns for stocks in comparison to the
value of CAPE at the beginning of each 17-year period.
chart therefore ends in July 2017 with the period that began with the year 2000,
the year of the stock market crash. The correlation of the two lines again is
very high. In this example, in the year 2000 the CAPE was at about 44 just as
the market peaked. What did the market return over the next 17-year period?
The average was about 4.9%, which is less than half of normal stock market
returns. By comparison, investment grade bonds returned 5.2% - more than
stocks! - annually during that same 17-year period. Stock market average annual
returns spanning a 17-year period that low occurred only one other time, the
period following the 1929 stock market crash.
The CAPE ratio suggests that buying US stocks at today’s prices, reflecting a
CAPE of 30, should be accompanied by realistic expectations of lower than normal
returns for a substantial period.
Department of Labor regulation referred to as the fiduciary rule, put in place
by the Obama administration, took effect June 9, 2017. The fiduciary rule, an
historic (albeit limited) step forward for investors, generally requires
financial service providers (such as investment advisors, stock-brokers, and
insurance agents) working with retirement accounts to serve as fiduciaries.
(Grossman Financial Management serves clients in a fiduciary capacity at all
times, and always has.)
Crisis regulatory measures designed to protect investors now face fierce
pushback from the financial services industry and its allies in the
Administration and Congress. The brief yet too colorful role of Anthony
Scaramucci (for details related to the fiduciary standard, see my previous
letter), is indicative of the Administration’s intent. The Administration and
Congress have already begun a variety of financial protection regulatory
roll-back initiatives in such areas as Dodd-Frank financial stability
regulations, the Volcker Rule on separating securities trading from banking, the
fiduciary standard, the Consumer Financial Protection Bureau (CFPB), mandatory
arbitration clauses in contracts, and waivers of rights to participate in class
Expect the Administration to continue to vigorously challenge investor
protections and advance corporate interests in the financial services industry.
The current economic
landscape suggests that investors should continue to expect more modest returns
than usual and remain defensively positioned. Our reading of the latest
economic and, moreover, political indicators suggests increasing risks ahead.
continue to recommend that investment portfolios lower normal allocations to
stocks, emphasize high quality securities (both stocks and bonds), and include
meaningful inflation hedges.
560 First Street,
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