• Long-term (10+ years) balanced portfolio returns expected to be in 4% to 5% range.
• Intermediate-term Treasury yields are foundational rates for setting required rate of return for bonds generally, stocks, real estate and many other assets
• Stocks earnings yield is more useful in comparing stocks to bonds than stocks P/E; by evaluating spread between earnings yield and Treasury yield
• Stacking Fed Funds rate, 10-year Treasury premium to Fed Funds, and stocks premium to 10-year Treasuries implies long-term GAAP P/E range of 12.5 to 20 versus current 25.2
• Dividend yield-to-Treasury yield was important for valuation for decades; then lost investor interest for decades; and may once again be gaining prominence as part of stock market valuation.

The broad consensus is that portfolio returns over the next decade will be significantly lower than the last decade, and even the last several decades. Institutions and professional prognosticators have varying explanations as to cause and varying estimates, but few disagree that return expectations must be tempered.

Generally, it appears that the consensus centers around an expectation for a balanced stock/bond portfolio to generate somewhere in the 4% to 5% total return over the next decade.

McKinsey & Company (a leading management consulting firm) published a May 2016 report titled “Diminishing Returns: Why Investors May Need To Lower Their Expectations”. They presented historical return data showing more recent returns higher than longer-term returns, and discussion of multiple factors that suggest a reversion to longer-term return levels is baked in the cake. 

This table presents historical annualized total nominal return data for US large-cap stocks and intermediate-term US Treasuries from the McKinsey report for 100 years, 50 years and 30 years; and also for Vanguard mutual funds focused on those same assets for 15 years, 10 years, 5 years, 3 years and 1 year. It also provides our calculations of how various stock/bond allocations would have worked out over those time periods.

The loud and clear implication of the data is that very recent returns are well above multi-decade returns, which in turn are above 100 year and 50 year returns. The cries out MEAN REVERSION as a likely process to drive portfolio returns over the next decade or more. The short-term could be anything, high or low, but the long-term is likely subject to a gravitational pull of very long-term returns.

This letter looks at Treasury interest rates and earnings yield-to-Treasury yield spreads as an explanation of why mean reversion must occur.

(click images to enlarge)

The McKinsey study sees the next 20 years producing US stock returns of 6.0% to 6.5% and 10-year Treasury bonds producing returns of 2.0% to 2.5% in a slow growth environment (the more likely case); or 8% to 9% for stocks and 3.5% to 4% for bonds in a growth scenario (the less likely case).

In their base case, taking the mid-point of their ranges, a 50/50 portfolio would therefore be expected to produce about a 4.25% total return over the next 20 years.

That will not support the assumptions built into the pension funds backing millions of retiree pensions, or the low level of annual pension funding by corporations, unions and governments for their defined benefit plans. Nor will it produce the kind of end of work-life assets in 401-k plans that were part of the expected result of switching from defined benefit plans to defined contribution plans (other than relieving employers of a cost and liability).

Pension plan sponsors will have to pay in a lot more, or defaults may occur. Individuals will have to save and invest a lot more, or retirement income security goals will not be met.

For example, according to a leading pension plan consulting firm, Callan & Associates, the average long-term return assumption for the nearly $4 trillion of state pension plans is 7.62%. That is a far way from the 4% to 5% expected for a plan vanilla 50/50 balanced portfolio. For the past 10 years those state plans averaged 5.8%, but for the past 25 years they averaged 8.3%.

Individuals will now need a lot more saved up for retirement too (the subject of our next client letter).

• Bill Gross, who is quite concerned about things not working out well as interest rates normalize, sees balanced portfolios generating something in the vicinity of 4% to 5% over the next 10 years.
• Vanguard founder John Bogle sees US stocks returning around 4% to 5% over the next decade, and aggregate corporate and government bonds returning around 2.5% (about 3.25% to 3.75% for a 50/50 balanced portfolio).
• There are some very bearish thinkers out there such as GMO led by Jeremy Grantham. They see nominal returns over the next 7 years of about negative 1% on US large-cap stocks, and about negative 0.1% on US government bonds (negative 0.55% for a 50/50 US large-cap stocks/Treasury bond allocation).
• BlackRock (world’s largest money manager), State Street (sponsor of SPDR funds), and JP Morgan see long-term US large-cap stock returns of 5.1%, 6.0% and 7.0% respectively; and US aggregate bond returns of 1.9%, 2.8% and 4.25% respectively. The average of their views is 6.0% for stocks and 3.0% for bonds; and about 4.5% for a 50/50 stock/bond portfolio. That effectively predicts mean reversion to the approximate 100-year and 50-year returns published in the McKinsey report.

Treasury rates

10-year Treasury rates, the effective benchmark rate for so many purposes, is at the lowest level since 1871 (135 years).

The closest rates came to this low level was during World War II, but they just basically touched 2%. As of last Friday the bond yielded 1.60%; and on July 5, 2016 the yield hit its all-time low of 1.37%.

Given that about 1/3 of developed markets government bonds have negative yields (the investor pays the government for the privilege of borrowing the money from the investor for years at a time) it is not impossible that US Treasuries have meaningful yield downside left, but that is not likely; and would indicate much greater problems with the economy and corporate profits and stock prices. Right now the German 10-year is negative 0.05%, the Swiss 10-year is negative 0.52%, and the Japanese 10-year is negative 0.02% — and they have been lower.

The chart below shows the monthly history of the US 10-year rate for 135 years. It shows the 135-year median yield as 3.88% and the 50 year median as 6.30%. We should think of those as gravitational forces, not necessarily to be reached any time soon, but as exerting a strong long-term mean reversion force for rates to rise rather than fall.

Since the peak of interest rates in 1982, the large decrease in rates over those 30+ years has provided a capital gain tailwind to bonds (bond prices rise when market yields fall). That tail wind could possibly be a small gust if rates fall further briefly, but the prevailing winds will be for upward movement in rates, which will create downward pressure on bond prices, which will subtract from the yield component of total return.

So Treasuries (the basis of virtually all other investment required rate of return decisions – meaning stock price multiples, real estate capitalization rates, and mortgage rates as examples) are a key element in evaluating the prices of other assets.

Bonds generally are likely stay at current levels until Fed Funds rates begin to rise. There is a possibility of further Treasury yield declines, but they would likely be short-lived and of small magnitude. For the long-term, yields will rise toward historical levels and mute the returns from bonds.

US large-cap stock prices

The common parlance uses P/E multiples (price divided by earnings) to describe stock valuation – how much you pay today to buy a current $1 of company earnings. A more useful ratio is the “earnings yield” (E/P = earnings divided by price) – how many earnings dollars the company is producing per dollar of purchase price at the time of purchase.

Why is E/P better than P/E? Because, it is easier to compare a bond yield to a stock yield, than to compare a bond yield to a stock price-to-earnings ratio. If you are good with math and work with the numbers all of the time, maybe either comparison is easy, but earnings yield compared to bond yield is immediately clear. By subtracting the bond yield from the earnings yield, you get the “yield spread”.

When the yield spread is positive (stock yield higher than bond yield), stocks tend to be more attractive than bonds. When the yield spread is negative (stock yield lower than bond yield), bonds tend to be more attractive than stocks.

Of course on an individual stocks basis, there are massive differences in credit quality, growth prospects, management effectiveness, etc., which overwhelm the yield spread question; but on a total market basis the yield spread is a particularly important relative value consideration. Earnings growth prospects are still important, but over the long-term growth trends to an average and the yield spread may say a lot, if not more, about long-term stock price appreciation potential.

So what does the US large-cap stocks (S&P 500 and precursors) yield spread say about stocks' appreciation potential?

This chart shows the rolling yield from 1871 through mid-2016.

Over the full history, the yield spread median was 2.87%, and over the last 50 years the median was negative 0.54%. As of mid-2016, the yield spread was 2.53% — essentially at the 135 year median and way above the 50 year median.. That suggests that stocks are probably reasonably prices relative to interest rates. Yes, stocks have high P/E ratios, but bonds have low yields, and now we can see quantitatively, instead of just qualitatively, that stocks and bonds are moving in a logical way relative to each other.

Certainly, one could argue, and I do, that with the poor showing for earnings growth, a secondary level of review suggests stock are still expensive.

That argument is countered, though, by those who believe the 2017 and 2018 earnings growth forecasts. Those forecasters expect earnings to be put back on track, As of 06/30/2016 the trailing reported GAAP earnings for the S&P 500 were $86.88 (down for 5 quarters in a row, the last time being 2009, and the time before 2001), but the data provided by Standard & Poor’s looks forward to $113.86 by 06/30/2017 (a 31% increase), and $122.10 by 12/31/2017 (a 41% increase 18 months from now).

Those projections are highly (actually massively) dependent on an oil price recovery. I’m still from the “Show Me” state of Missouri on those forecasts.

So, if stocks are “fairly” valued relative to 10-year Treasuries, why all the doom and gloom about long term stock returns?

The problem is that if stocks are in line with current interest rates, and if interest rates are bound to rise, and if stocks continue to be in line with interest rates, then stock returns would be subdued going forward (either by a significant drop followed by rebuilding, or a path of price growing more slowly than earnings until the yield spread returns to a reasonable level). Of course, you can see from the chart that yield spreads vary widely, but when thinking about the long-term it is important to thinks about medians and averages.

The GAAP earnings yield right now is 3.97% ( P/E = 25.2) and the yield spread is 2.37%. The long-term yield spread is somewhere between the 2.53% of the past 135 years, and the negative 0.54% of the past 50 years (mid-point = about 1.5%).

So if the 10-year Treasury were to recover to say 4% (based the Fed Reserve “dot plot” forecast plus the typical yield spread between the Fed Funds rate and the bond), then US large-cap stocks would need to have an earnings yield between about 6.5% (P/E = 15.4; generally thought of as a reasonable long-term fair multiple) and 3.5% (P/E = 28.6) to be in the 135 year to 50 year range.

A 15 P/E multiple is a lot more plausible than one of 28. A change from a P/E of 25 to one of 15 would be either a drop in price of 40%, or rise in earnings of around 67%, or combination.

FED Funds rate – 10-year Treasury yield spread

Over the past 60 years, the 10-year Treasury yield has been 2.5% or more above the Fed Funds rate when the Fed is stimulating and/or times are good and rates are rising with a strong economy. The spread narrows to zero or less when the Fed puts on the brakes; and that presages a recession.

The Fed Funds rate like the 10-year Treasury is at historic lows, and the Fed is evaluating when to let it “normalize”. This chart shows the long history of the Fed Funds rate.

In their published “dot plot” the Fed shows the separate opinions of the Fed presidents who are members of their decision committee.

Net impact on stocks

Somewhere between P/E multiples of roughly 12 and 20 (likely y 15 to 16) is in store long-term for stocks (earnings yield of 5% to 8+%)..

The Fed sees 1.5% for the Fed Funds rate by the end of 2017. That plus 2.5% would imply a 4% 10-year Treasury, and all that may mean for bond prices and stock prices.

Add into your thinking the 3% Fed Funds rate they see long-term, and the 5.5% 10-year Treasury that implies for the long-term, and the 5% to 8% earnings yield (based on 50-year ad 135-year median spreads), and you see long-term P/E ratios from 20 to 12.5 for US large-cap stocks – both multiples significantly lower than today.

Of course, the growth rate of earnings factors is important too (P/E divided by Growth Estimate – PEG), but over a full business cycle growth should move to long-term trend. Whether the world economy is slowing for this or that reason (such as the demographics of aging populations as a slowing factor; or the rise of emerging markets middle class as an accelerating factor) is yet to be unfolded.

In our next letter we will discuss the implications for these possible futures on necessary savings for retirement, portfolio withdrawal rates in retirement, and several different approaches to withdrawal management.

Postscript on dividend yield to Treasuries spread (caution strong opinion follows):

It is still unclear how much the stocks dividend-to-Treasury yield will play in the long-term in the price setting process. As you can see from this chart, for almost 90 years, stocks had dividend yields equal to or higher than Treasury yields – generally spreads of 0% to 4%, with a lot around 2%.

That made sense for two important reasons. First, investors felt they needed to receive cash-on-cash continuing returns for the risk they took investing in stocks with no guarantee of return of capital; and second, they did not want to have to sell their investment to make a return – because what fool would have wanted to buy a piece of paper that did not result in a cash-on-cash return during ownership (Oops! Maybe that argument applies today too?!).

Then in the late 1950’s modern portfolio theory came about, basically stating that it was tax inefficient to pay corporate tax and then dividends received tax; and that corporate managements had better opportunities and better judgement to invest corporate profits on behalf of the owners. That retention of all cash flow in turn would amplify the growth in value of the company and produce larger capital gains upon sale of the stock. So somehow investors collectively drank the cool-aid and allowed management to withhold dividends and reinvest the cash, turning stock investing significantly more toward measuring earnings than measuring dividends to value stocks.

Before that time the definition of value was the Dividend Discount Model (how much is the present value of the expected dividend stream worth discounted into perpetuity).

However, once investors got duped (sorry, I meant convinced) that receiving dividends wasn’t all that important, the valuation approach became discounting into perpetuity the earnings or cash flow of the company that the investor would never receive.

That approach to valuation reduced management accountability to shareholders, by removing the strong discipline that paying dividends while building the company imposes. Management was then more free to build the company oftentimes in ways more beneficial to their own compensation or egos of the executives, than to the ultimate benefit of shareholders. Managements put forth all manner of earnings overstated by “unusual” and “one-time expenses”.

Eventually, the analysts who in many cases had employers whose bread was buttered by representing the companies being analyzed, began to put forth valuations based on “operating earnings” that focused on the earnings excluding the “unusual” and “one-time” expenses, that seemed to occur in different forms every year anyway — you know, except for this or that billion dollar write down, everything is good.

Paying dividends requires more executive discipline and stronger capital management than not paying dividends.

Then inflation took off big-time and those dividends that were being paid could not keep up, forcing the dividend-to-Treasuries yield spread into negative territory where it remained for about 50 years. However, as inflation subsided allowing Treasury rates to moderate, the yield spread improved, due to a combination of declining interest rates and rising dividends.

Now we are back to dividend yield and Treasury yields close to each other with dividend yield ahead – 10-year Treasuries yield about 1.6% (ordinary tax rate) and the S&P 500 yields about 2% (lower dividends tax rate). That is mostly because the Fed has suppressed Treasury yields so much, but also because more and more companies are paying dividends than they did before; and more are increasing dividends; and more are seeing investor demand for dividends to support stock prices – at least for many mature businesses.

Clearly, early stage companies can’t pay dividends, and companies with fantastic growth and investment opportunities may actually better serve investors by reinvesting all cash flow, BUT for a mature company with modest growth prospects to withhold dividends to find ways to buy this and that company to achieve non-organic growth (and enrich executives along the way) just doesn’t compute for me.

For investors in pre-retirement and retirement situations, the vagaries of stock market price multiples should be moderated not only by diversifying with bonds and other assets, but also by making sure that the overall basket of stocks owned pay a reasonable dividend, with reasonable dividend growth history and prospects. Trying to live in retirement based on selling assets with volatile prices is not a formula for success.

That said, there has been so much dividend chasing by investors who would have otherwise put the money into bonds, the pickings are not all that great for dividend yield seekers right now.

Assuming that the newly revived investor demand for a share of corporate cash flow in the form of dividends will persist in great part due to the aging population and underfunded retirement portfolios, it may be a reasonable speculation that the dividend-to-Treasuries yield spread will become more important going forward in driving stock price multiples as Treasury yield rise.

If total returns are expected to be lower going forward, and possibly less certain, then investors should be all the more focused on making sure that they get paid along the way when they own stocks.