GMO Real Return Forecasts

Transcription

1 GMO Real Return Forecasts GMO Real Return Forecasts Jeremy Grantham s firm GMO makes a monthly 7-year Forecast which has been reasonably accurate over the years. It is primarily valuation based. For example, here s the most recent one: These are estimates of the annualized after-inflation return for a particular asset class over the 7 years beginning 1 November Some of the asset classes are pretty selfexplanatory, such as US Large stocks, or the S&P 500. Others, a little less clear, such as index-linked bonds or timber. Finally, the US High Quality stocks (which seem to always have a high predicted return BTW) are anyone s guess as to what Grantham/GMO means. Here is the explanation from the website: How do you define quality stocks? GMO defines quality companies as those with high and stable profitablility, and low debt. Sounds good right? But in reality, the definition is simply the stocks GMO selects for its US equity funds. Taking a look at their Quality VI fund using Morningstar, you see this that the fund is mostly giant growth stocks such as Pfizer, Microsoft, Coke, Johnson and Johnson, Phillip Morris etc. Interestingly enough, they didn t use the quality stock asset class in their predictions 7 years ago. The thing I like about GMO Forecasts is that they seem pretty reasonable most of the time. But the truth is you shouldn t take someone s current forecast, without looking at their past forecast. So let s do that too. Here are the predicted returns from May 31, 2004, or about 7 years ago. One of their

2 assumptions is 2.2% inflation, so in parentheses, I ve put the predicted nominal return. The reality was that inflation, at least measured by the CPI-U, was 2.5% per year over the last 7 years. Equities US Large Cap: -1.6% (0.6%) US Small Cap: -1.3% (0.9%) Intl Large: 3.2% (5.4%) Intl Small: 3.8% (6.0%) Emerging Markets: 6.4% (8.6%) Fixed Income Treasury Bonds: 2.2% (4.4%) International Govt Bonds: 2.5% (4.7%) Emerging Market Bonds: 4.7% (6.9%) TIPS: 2.2% (4.4%) Cash/Treasury Bills: 1.4% (3.6%) Other REITs: 3.7% (5.9%) Managed Timber: 7.0% (9.2%) So what were the actual returns for these asset classes, both real and nominal over the last 7 years? To make things easy, let s use July 1, 2004 to June 30, Some of the asset classes are easy to replicate, some a little more tricky. 4 of the asset classes have an index or an index fund now available, but the data isn t readily available for the full 7 year period, so I unfortunately have to omit these from the analysis. If you have access to this data, please forward me a link. Asset Class Vehicle Predicted Rank Actual Rank Predicted Real Return Actual Real Return Diff

3 US Large Cap US Small Cap Intl Large Intl Small Emerging Markets Treasury Bonds Intl Govt Bonds Em Mkt Bonds VG 500 Index VG Small Index VG Dev Mkt Index No 7-year data VG Em Mkt Index VG Int Treas Fund No 7-year data No 7-year data % 1.70% -3.30% % 5.20% -6.50% % 4.04% -0.84% N/A N/A 3.80% N/A N/A % 14.84% -8.44% % 3.43% -1.23% N/A N/A 2.50% N/A N/A N/A N/A 4.70% N/A N/A TIPS TIP ETF % 3.29% -1.09% Cash REITs Managed Timber VG Treas MM VG REIT Index No 7-year data % -0.30% 1.70% % 6.48% -2.78% N/A N/A 7.00% N/A N/A Here we see a few things. First, GMO underpredicted returns by an average of 2.8% per asset class. Second, subjectively, they really missed the boat with small US stocks (predicted a loss, but they had a large gain) and emerging market stocks (severely mispredicted the magnitude of the gains). Last, with the exception of small cap stocks, they correctly predicted the rank of the other asset classes.

4 Predicting the future is hard. No matter what method you use, there is no such thing as a clear crystal ball. There are two things you can do to improve your accuracy. First, use a long time period. Predicting returns in the next few months or years is particularly difficult. Second, use valuations. Over the long term, Bogle s speculative return from the excessive greed and excessive fear of market emotions cancels itself out. We end up being left with the fundamental return. So to predict that return, you should naturally use fundamentals. It also becomes obvious that some areas are very hard to predict. Cash, for instance, is heavily dependent on government-set interest rates. The government sets rates based mostly on political and economic events you cannot readily predict years out. I would take any prediction of short term interest rates with an entire shaker of salt. Longer-term bonds, however, are much easier to predict. The best prediction of the return of a bond is its current yield. The yield on 7 year treasuries in mid-2004 was about 4.5%. Subtracting out 2.5% for inflation, that leaves with an expected return of 2%. What was the actual return? 3.4%. A little higher than expected due to the falling interest rate environment, but still pretty close. Likewise, the 7-year TIPS yield was 1.8%. Actual return was 3.29%, again a little higher due to falling interest rates, but close. So how can you use these predictions in managing your portfolio? First of all, I would caution against markettiming, even in the long-term. For the most part I recommend you stick with a fixed asset allocation and rebalance each year. Second, if you choose to make some adjustments based on valuations and long-term predicted returns, do so with a small percentage of your assets. This concept of tactical asset allocation should be limited. For example, if your plan calls for 50% stocks, you might bump that up to 55% if you

5 expect high returns from stocks, and down to 45% if you expect lower returns. It s okay to make a bet, but be sure to consider the consequences of being wrong. Third, diversify, diversify, diversify. Just because EM, small stocks, and timber are the asset classes predicted to do well, you don t want a portfolio composed only of these classes. Not only will it be (likely) intolerably volatile, but if the prediction is quite wrong (like the small stock prediction noted above), your returns will take a beating. Lastly, consider adding new asset classes to the portfolio from time to time, especially when valuations suggest strong future returns. GMO has been predicting strong returns from timber for years. But the ETFs CUT and WOOD only became available in 2008 and 2009 respectively, and have shown quite high correlation with the overall stock market. Vanguard didn t come out with a small international stock index fund until 2009 and their actively managed fund was closed to investors off and on prior to that. Predicted returns can give the investor some guidance about adding a new asset class when there isn t much of a track record to consider, and also provide some caution when there is an impressive track record behind the asset class. In conclusion, crystal balls are always cloudy, but Jeremy Grantham s is clearer than most. If you want to check out another opinion, take a look at Mauldin s book with the link below. You might also take a look at Ed Tower s paper about the GMO forecasts. Bull s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market

6 Expected Returns Like what you re reading? Buy the book on Amazon! One of the most important concepts for the investor to understand is that of expected returns. Expected returns are, of course, not guaranteed returns, but an investor who doesn t have any idea of the range of possible future returns is likely to make significant errors in investing. A common error is to save too little. For example, an investor who expects an investment to return 15% when it only returns 5% will save far too little to reach his goals. Another common error is to buy high and sell low. This occurs when an investor doesn t realize that a risky asset class can drop 40%, 50% or even more over a relatively short time period. The investor panics and sells his investment to a more patient investor with a more realistic view of expected returns. So how does one estimate future returns? Probably the best place to start is in the past. If you re expecting an investment to return you 20% a year, but it s long term returns have been only 10% a year, then you re likely in for a disappointment. The overall US stock market, the most successful one in the world over the last century, has had a return over the last 110 years of 9.4%, approximately 4.8% in price appreciation and 4.7% in dividends. That number, of course, is prior to inflation, taxes, and investment expenses. Inflation alone has been 3.19% a year from so the real (after-inflation) return has been 6.2%. You can

7 subtract taxes and expenses from there. You can quickly see that any adviser who suggests you rely on 10% investment returns to reach your goals is already setting you up for failure. Although that is common, there are plenty of people out there who would lead you to believe that even higher returns are possible. Dave Ramsey, for instance, does a fantastic job helping people get out of debt. Unfortunately, once they re out of debt he recommends they get into good growth stock mutual funds which will then return them 12% a year. Recently, there was a bust of a Ponzi scheme in my area where the investors were sucked in by promises of returns of 18% a year. If an investment is promising three times the long-term return of the stock market (which at one point lost 90% of its value), you can bet it will be at least three times as risky. To make matters worse, many investing gurus are cautioning people that the future expected return of the US stock market is far lower than the past returns. To understand why, you need to understand where returns come from. John Bogle, in his investment classic Common Sense On Mutual Funds, teaches that returns come from three components, the dividend yield, the earnings growth of the underlying companies, and the speculative return. Over the long term, the speculative return becomes a non-factor. At times people are far too optimistic about the stock market, such as 1999, and they bid stocks up to ridiculous prices. At other times, such as late 2008, people are far too pessimistic, and stocks sell at a discount. But over the long run, these excesses cancel each other out. So long-term returns really only come from the dividend yield and from the growth of earnings. Remember that from about half the return came from dividends (4.7%.) Now, think about the current dividend yield of the US stock market, 1.8%. Assuming the earnings growth of the companies that make up the US stock market remains about the same in the future as it has

8 been in the past, long-term returns going forward look to be about 2.9% lower than they were in the past. Is that assumption reasonable? Well, economic forecasts for the next several years call for growth of 1.9% to 3.1% per year. Luckily, that s an after-inflation number. So if the current dividend yield is 1.8%, and expected growth is 2.5%, a reasonable long-term expected real return on the overall US stock market would be 4.3% going forward. This is similar to how the Gordon model estimates future returns. To make matters worse, bond returns are also expected to be low in the future. It turns out that the best estimate of future returns on highquality bonds is the current yield. The current yield of the US bond market is 2.8%. Unfortunately, that s a nominal, preinflation number. If you subtract out an expected 3.2% for inflation, you re left with a negative real return. So a portfolio composed partly of stocks and partly of bonds is likely to have an even lower return than the 4.3% noted earlier. So what is an investor to do? There really are only three choices. First, you can save more and for longer. This is probably the safest of the options. As discussed in yesterday s post on the future value function, we see that if you decrease the rate of return, you must increase either the amount added to the portfolio each year or the number of years the portfolio has to compound that return if you hope to arrive at the same place. Second, you can take on more investment risk. There are riskier asset classes than the overall US stock market. In general with investing, higher risk carries the possibility of higher return. Asset classes such as small stocks, value stocks, and emerging market stocks have higher expected returns than the overall market. Rick Ferri, in his excellent All About Asset Allocation (2006), lists the following expected returns for various asset classes:

9 Asset Class Real Return Treasury Bills 0.5 Intermediate-term Treasury Bonds 1.5 Long-term Treasury Bonds 2.0 GNMA Mortgage Bonds 2.0 Intermediate-term Muni Bonds Intermediate-term Corporate Bonds Long-term Corporate Bonds 2.8 Preferred Stocks 3.5 High-Yield Corporate Bonds 4.0 Emerging Market Bonds 4.0 US Large-cap Stocks 5.0 US Micro-cap Stocks 7.0 US Small Value Stocks 7.0 REITs 5.0 International Developed Large-cap Stocks International Developed Small-cap Stocks International Emerging Market Stocks

10 While many would quibble about the actual values in this chart (especially given the current, hopefully temporary, low-yield environment) and the wisdom of investing in many of the asset classes listed, the point is clear. If you have a portfolio with a large number of small stocks, value stocks, and riskier international stocks, your expected return (and risk of temporary and permanent loss) is higher than that for one who holds only a US total stock market fund. Also, the lower the percentage of bonds you hold in the portfolio, the higher the expected return. Naturally, a portfolio composed entirely of emerging market stocks brings on its own problems and is NOT recommended. Lastly, an investor can hope that alpha can be added to his returns. This is the additional return possible from superior security selection and market timing. The number can be positive OR negative, depending on the skill of the manager, and, for all investors as a whole, is zero, before expenses (well below zero afterward.) Unfortunately, the data show that this skill is quite rare and probably shouldn t be counted on to add significantly to returns.

11 Another reasonable estimate of future expected returns is published each year by Jeremy Grantham s GMO firm. This is updated every year based on current valuations. It hasn t been perfect in the past, but it seems to be relatively accurate. It suggests real returns for common asset classes over the next 7 years will be anywhere from -2% to 4%. I m sure to many of you the expected returns I ve discussed above seem quite low. I know how disappointing that can be. But hope isn t much of an investment strategy. Given how low future expected returns are likely to be, it is all the more important that the wise investor reduce the bite of taxes and investment expenses on the portfolio returns. The bottom line? Have a realistic view of what you can expect from investing over the long-term. If you do not, your investment plan will likely result in failure due to your own behavior. When estimating future returns for your portfolio, use after-inflation, after-tax, after-expense returns that are realistic, such as 2-6%.