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For Stock Returns, Yesterday’s Gone and Tomorrow’s Expected to Be Weak

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On Fleetwood Mac’s 1977 hit album, Rumours, Christine McVie wrote the popular lyrics: “Don’t stop thinking about tomorrow.”

While she may have been referring to her separation from her then-husband (and bandmate), John McVie, a new Research Affiliates paper uses these lyrics as a sort-of motto for its future capital market return expectations.

“We do not share the song’s confidence that ‘it’ll be better than before.’ But, certainly, ‘yesterday’s gone, yesterday’s gone,’” write the paper’s authors, Chris Brightman and James Masturzo, both CFAs.

The paper, titled Yesterday’s Gone: Year-End Capital Markets Commentary and Expectations, examines long-term historical returns to come up with its 10-year expectations for returns of various asset classes — which is this: The performance of U.S. stocks and bonds over the next 10 years will be significantly lower than long-term historical averages, while other asset classes may produce moderately better returns.

Here’s how they got to that point:

By limiting the analysis to a simple 60/40 portfolio of U.S. stocks and bonds, they were able to interpret the historical record in light of the starting conditions following another long bull market.

Looking at 100 years ago, the paper finds that “an investor in 1915, investing in the 60/40 portfolio, and reinvesting all cash flows for the next century, earned an annual nominal return of 8.4%, composed of 10.3% from equities and 5.6% from bonds.” And Research Affiliates found that investing in the 60/40 portfolio over more recent periods also produced good results.

In the last 50 or even 25 years, the paper states the 60/40 portfolio “resulted in even better annualized nominal returns, with U.S. bonds picking up some of the slack from a slightly lower U.S. equity market return.”

Brightman and Masturzo are tempted to extrapolate these past returns into future expectations, but they know better.

They first look at some of the conditions of the past century that provided strong tailwinds for financial markets, compared with today’s environment.

The last century saw drastic improvements in the technological, social, and health-related fields — such as Henry Ford’s first moving assembly line and the standardization of indoor plumbing and home electrification, as well as women joining the work force and declining infant mortality rates.

“This is not to say that technological, social, and health-related advancements will not continue to occur over the next century. However, it is fair to pose a question about the marginal importance of future advancement relative to the past,” write Brightman and Masturzo. Adding “Can we expect the same financial tailwinds from future advancements? Only time will tell.”

The paper then looks at the past decade — in which, despite the slow economic recovery, U.S. stocks and bonds have produced high returns over the very long term and respectable returns over the past decade.

“The past decade has seen ultra-low interest rates, a housing bubble, the global financial crisis, the Great Recession, global unemployment at levels not seen in decades, and now a slow and geographically uneven global economic expansion,” write Brightman and Masturzo. “With all that turmoil, surely the 60/40 portfolio suffered mightily during this time! Well, actually, no.”

What their analysis found was that the 60/40 portfolio earned a “respectable” annual nominal return of 7.2%, or 5% real, over the past decade.

And despite all positive historical analysis, Brightman and Masturzo still don’t believe the future, as Fleetwood Mac insists, will “be better than before.”

Research Affiliates looks ahead to the next 10 years, using the simple and reliable model assuming that starting yields predict future returns.

“The lower the starting yield, the lower the subsequent 10-year return of the index,” the paper states. “We can’t look at this plot of returns and starting yields and, knowing that we start today with 2% bond yields, expect bonds to provide over the next 10 years the 8% return they provided over the past 50 years. We know that 2% bond yields means 2% bond returns.”

Finding the same relationship with stocks, that starting yields determine future returns, Brightman and Masturzo expect U.S. stocks and bonds to both produce substantially lower returns in the future.

And while they find that prospective returns are not very high anywhere, they do expect other asset classes, like emerging market stocks and bonds, to outperform mainstream U.S. investments in the coming 10-year timeframe.

While some argue that globalization will “continue to propel corporate profits to an ever-greater share of economic output for a few more years” or that quantitative easing will facilitate “financially engineered growth in earnings per share through an unprecedented quantity of stock buybacks,” Brightman and Masturzo don’t buy into this.

“[T]hese trends cannot continue indefinitely and seem more likely to reverse than continue over a 10-year horizon,” they write.

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