Whose Expected Return is it Anyway

• We invest in assets that we expect to earn a return. Expected returns are currently derived in two distinctly diverse ways.
• Expected bond returns rest on Federal Reserve actions, since they are manipulating bond prices.
• Momentum is driving stock prices. How long can that last?

A trend is a trend is a trend

But the question is, will it bend? 

Will it alter its course 

Through some unforeseen force 

And come to a premature end?

- Cairncross

There’s much discussion about the possibility of stock and bond markets being in bubbles. It boils down to return expectations. It’s a bubble if prices are expected to tumble. It’s not a bubble if prices are expected to increase. It’s that simple. The following graph presents the choices. Pick one.

(Click on image to enlarge)

Bonds

The choice is easy for bonds. Will the Fed continue to manipulate bond prices to extraordinary highs, so interest rates are zero or even below zero - the Zero Interest Rate Policy (ZIRP)? Fed chairperson Jerome Powell has advised that “tapering” lies ahead which translates into “less manipulation.”  Bond prices will decrease, and yields will increase, unless the Fed reneges as it did in 2018 when it last tried to taper and stock prices plummeted.

Stocks

Stock prices are more complicated. Few deny that stock prices are above historical norms based on a variety pack of measures like Price/Earnings, the Buffet Bubble Barometer and the John Hussman Bubble Barometer shown in the next picture.

(Click on image to enlarge)

Can prices continue to go up? Of course, but what if they don’t, and prices return to more normal levels. That question is answered by the table on the right in the first exhibit above. There’s a formula that is a tautology for estimating future returns. It always works because it has to work.

Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1

As you can see in the green shaded area, stocks will earn positive returns if P/E multiples remain near current levels and earnings grow by more than 6%. Momentum saves the day.

But the market will lose 50% if P/Es return to their historic mean of 15 and earnings grow at their historic average of 6%. Regression toward the mean generates large losses.

What is your outlook for earnings growth in the stock market over the next 12 months? Where do you see P/Es a year from now? You can look up your cell (forecast) in the table above.

Future P/Es are driven by investor behavior

Choosing a future P/E in the table above is the key to generating a return forecast. And therein rests the debate about bubbles. Behavioral scientists tell us that we are not rational because we all have biases that cause us to behave irrationally. Samples of these biases and the irrational behavior they cause are as follows:

Conclusion

Time will tell. A bubble is not recognized until it bursts. In the meantime, FOMO (Fear Of Missing Out) remains today’s version of the “The Trend is Your Friend” mantra of the 1990s growth bubble.