A very smart analysis of expected future returns, decomposition of returns and the interplay of valuation and time frames.
From RealInvestmentAdvice, May:
Is a “lost decade” ahead for markets? We and many others have discussed a topic regarding financial market valuations and forward returns. Now, halfway into 2022, all of a sudden, the “crazy talk” of valuations seems a lot less crazy as bear markets growl.
However, it wasn’t that long ago the mainstream media discounted valuations and forward returns. For example, in December 2021, Ben Carlson recounted a presenter at a 2010-2011 conference who discussed valuations for a 60/40 allocation in the 95th percentile. Historically, that suggested investors were doomed for a low-return environment of roughly 2-3% over the next decade. As he states:
“Instead, this happened.”
“U.S. growth is up almost 20% per year. The S&P 500 is up more than 16% per year. Small caps are up almost 14% per year. REITs rose more than 11% annually. Everyone has been dancing on the grave of value stocks for years now, yet they’re up nearly 14% per year over the last decade.
A simple 60/40 portfolio of U.S. stocks and bonds is up around 11% per year over the past 10 years.”
Valuation and forward return assumptions were wrong then.
Or were they?
Over the last 120-years, valuations have consistently proved to be a strong predictor of future returns with lost decades a common occurrence. However, as we discussed previously in “Rationalizing High Valuations:”
“The mistake investors repeatedly make is dismissing the data in the short-term because there is no immediate impact on price returns. Valuations by their very nature are HORRIBLE predictors of 12-month returns. Investors avoid any investment strategy which has such a focus. In the longer term, however, valuations are strong predictors of expected returns.”
The chart below shows valuations and rolling 10-year total real returns. The obvious conclusion is that overpaying for value leads to lost decades.
However, let’s go back to Ben’s comment above. In 2009, valuations had corrected significantly, not only from the “Financial Crisis” peak but also from the preceding “Dot.com” bubble. Therefore, investors should have expected forward returns on equities to be higher over the next decade....
That second chart in its various manifestations is one of the most illuminating in all of finance.
As the old pros used to say, "Well bought is half sold."
