Index Stock Market Expected Returns Page 2 Stock Market Returns Page 3 Investor Returns Page 13 Advisor Returns Page 15 Elections and the Stock Market Page 17 Expected Returns June 2017 Investor Education Investor Education is Critical to reach your Financial Goals Wealth gives you Freedom and Control of your Life Setup an Auto-Investment Plan to Invest on a Regular Basis in Bull and Bear Markets Create a Diversified Portfolio with the Proper Asset Allocation Purchase Quality Investments Manage your Portfolio Properly PDM Investment Services, LLC A Registered Investment Advisor 5131 Standish Drive, Troy, Michigan 48085 1-248-890-4696 * www.fginvestor.com * info@fginvestor.com For complete disclosure see our website 1
Stock Market Return Expectations S&P 500 (2017) Annual return predictions should be calculated over the long term of five to ten years. Expected returns are much higher after a bear market when valuations are low than in a mature bull market when valuations are high. Stock appreciation is based on fundamental returns (earnings growth and dividend yield) and speculative return (valuation expansion). Earnings growth can change fast and valuation expansion (speculative return) is impossible to predict. Global growth has slowed to the 3.0% to 4.0% range and this will likely be the norm going forward. The developed countries like the United States, Europe and Japan continue to see low growth. Emerging market growth is higher, but slowing. Slowing productivity and demographics is hurting growth. Dividend yields over the past 100 years were around 4.0%, but have slowed to around 2.5%. The PE ratio of the S&P 500 (SPY) at the end of 2016 was 19.9 past/19.5 forward. The PE ratio is close to the average PE of 18, leaving no return for long-term expansion. Expected returns going forward are going to be low. Bond yields are low, so bond returns are likely to be low or negative as interest rates rise. Bonds will not contribute as much to the typical 70% stock & 30% bond portfolio like they have in the past 30 years. Stocks are fair valued so their contribution to portfolio returns will also be low. (Labor Force Growth + Productivity Growth Expectations = 2.0%) Since the 1980 s stocks and bonds moved together benefiting from falling interest rates, falling inflation and rising productivity. Alternative investments may fill some of the gap. The earnings growth, dividend yield and PE expansion indicator is predicting a 6.0% annual return going forward. (see calculation below) The earnings yield predictor is predicting a 7.1% annual return going forward. (1/19.5 forward PE = 5.1% + 2.0% dividend yield) The forward PE and subsequent 5-yr annualized returns indicator is predicting a 5.0% annual return. Expected Returns are based on past performance, a secular bull market and future expectations from various sources. Returns in the table reflect average annual S&P 500 total returns going forward, but are not guaranteed. For real return, subtract 2.5% for inflation. The global stock market performance, asset allocation and equity selection contribute to portfolio performance. Earning Dividends PE Total Return Expectations Growth Yield Expansion Next 5 Years (Annualized) Past Stock Market 4.0% 4.0% 1.0% 9.0% Future Stock Market 3.5% 2.5% 0.0% 6.0% High volatility and higher risk of loss Moderate Allocation Portfolio (75% stocks / 20% bonds / 5% cash) 5.2% Moderate volatility and less risk of loss Future Bond Mix 3.0% Money Market, CD or Short Term Bond Fund 2.0% Low volatility and limited risk of loss 2
Reasonable Expectations Expected returns must be reasonable. Anything else will get you in trouble usually with higher risk. High return and high-risk portfolios typically perform much worse than the stock market in bear markets. All you need is good enough returns to meet your goals based on risk tolerance level. Part of our life s success comes from skill and hard work and some comes from randomness or luck. Ask yourself why your investment choice or portfolio did well The contributors to excessive return years are listed below. Exceptional skill Rare (Look at past returns over a long period, process and strategy) Excessive risk works both ways Market environment changes through the market cycle Leverage works both ways Luck comes and goes Stock Market Annual Returns Annual market returns vary widely. You must understand that in a bear market most equity investments will lose 20% or more. Are you willing to take on more risk for the potential of higher returns? Higher risk portfolios often produce higher returns over time, but are more volatile. Lower risk portfolios often produce lower returns over time, but are less volatile. The list below shows the annual stock market returns since 1941 and how often they occurred. Source: Manifest Investing 3
Annual Return Predictions as of 2015 based on Valuations. The chart below shows how future expected returns of the stock market drop as valuations rise. Valuation based predictions were more stable over the 5-year period than the 1-year period. At the end of 2015 the forward PE of the S&P500 was 18. This equates to a 5% annual return over the next 5 years. 4
Stock Market Since 1990 Below shows the stock market from 1900 through 2014. See the secular bear markets during the 1900 s, 1930 s, 1970 s and 2000 s. Also see that over long periods of time the market has been on an upward trend. 5
Bear Markets and Subsequent Bull Runs Below is a chart of bull and bear markets and the macro environment that triggered them. Source: JPMorgan 6
History of U.S. Bear & Bull Markets Since 1926 The average Bull Market period lasted 8.5 years with an average cumulative total return of 458%. The average Bear Market period lasted 1.3 years with an average cumulative loss of -41%. The 1930 s, 1970 s and 2000 s were secular bear periods. 7
History of U.S. Bear & Bull Markets Since 1966 The average Bull Market period lasted 8.5 years with an average cumulative total return of 458%. The average Bear Market period lasted 1.3 years with an average cumulative loss of -41%. The 1930 s, 1970 s and 2000 s were secular bear periods. 8
Historical Returns by Holding Period The chart below shows that over longer periods of time stock market returns are less volatile and generally positive. Stock only portfolios are the most volatile with the highest returns, next is a mix of stocks and bonds and the least volatile and lowest returns is an all bond portfolio. 9
Year-by-Year Returns Below is a chronological display of the S&P 500 performance each year from 1928 through 2013. Mean Reversion Theory The Mean Reversion S&P 500 forecasting model is predicting a 14% annual total return over the next 20 years based on a mean reversion to a 10% total return, low valuations and low interest rates. The past 20 years saw a 6% annual total return, below the 10% mean. The next secular bull market should start by 2015, driving higher returns for about fifteen years. 10
Year-by-Year Returns and Intra-Year Declines Below is a graph of annual returns and the intra-year decline in that year. In order to participate in the bull market gains each year (bars above the lines), we must also endure the intra-year corrections during the year (bars below the line). 11
Stock Market Rolling Returns The numbers below are based on returns from 1900 to 2010. The worst period in the past 100 years saw a 1% annual return from 2000 to 2009. This was a secular bear market. A bubble at the beginning of the period and two devastating bear markets created these poor results. The second worst period saw a 2% annual return from 1930 to 1939. This was a secular bear market and the Great Depression. The third worst period saw a 3% annual return from 1966 to 1975. This was a secular bear market. The stock market saw an annual return of less than 8% for 43% of the past 10-year rolling periods. The stock market saw an annual return between 8% and 12% for 22% of the past 10-year rolling periods. The stock market saw an annual return of greater than 12% for 35% of the past 10-year rolling periods. Based on history, the stock market will start producing higher annual returns after these bottom lows as a new secular bull market emerges. The secular bull markets of the past produced 18% annual returns over 10-year rolling periods. The S&P 500 (PREIX) has produced a 16.7% annual return from August 2009 thru August 2014. Expected returns are much higher after a bear market when PE s are low than in a mature bull market when PE s are high. 12
Investor Returns Per a Morningstar Study, the 10-year gap between the average investor and average fund ballooned to 2.5% by the end of 2013. The typical investor gained 4.8% annualized over the 10 years ended December 2013 versus 7.3% for the typical fund. The biggest gaps were in the more volatile sectors of international equity at -3.0% gap and sector funds at -3.1% gap. Poor timing was the largest contributor. In 2012, taxable bonds saw the largest inflow of $270 billion, then in 2013 the category returned a -2%, one of the worst performers. In 2012, U.S. equity saw a -$94 billion outflow only to see the category return 34% in 2013. Much of the damage is from investors chasing performance and news coverage. Per Dalbar s Research, the average annual return of the do-it-yourself investor from 1984 to 2013 was 3.7%. Inflation +2.8% Average Investor +3.7% Portfolio Managers +9.1% (If 2% below the S&P 500) S&P 500 +11.1% The huge difference between investors returns and market returns is most likely due to individual behavior, particularly during down markets. Also poor diversification, poor timing, performance following, passive portfolio management, poor emotion-based decisions at market tops and bottoms, bad investment strategies, poor asset class allocation, closed architecture, poor security selection and high costs are a drag on their performance. A good Investment Advisor underperforming the S&P 500 by 2% per year and with a 1% management fee still adds +4.4% value over the doit-yourself investor. Advisors add more value than just portfolio performance. They also provide wealth building plans, discipline, peace of mind and investment advice. After reviewing portfolios for the past 10 years, it has become apparent that the individual investor should not try to manage their own investments without the proper training, tools and dedication. The investment world continues to get more confusing and complicated. Most people find it difficult to even construct and maintain a recommended portfolio. They purchase a few investments and create a poorly designed portfolio that underperforms. Buying individual stocks is much more difficult than mutual funds and not recommended for most individuals. You should always seek professional advice unless you get the proper training, invest in the tools and are willing to put the time into portfolio design and management. 13
Investor Returns Diversification and the Average Investor Below you can see how the average investor underperforms the stocks market an a diversified 60% stock/40% bond portfolio. 14
Advisor Returns A good portfolio manager aims to outperform the benchmark that it tracks based on a clients risk level. The Morningstar Conservative, Moderate and Aggressive Risk benchmarks are a good place to start for portfolio managers. Unless you are in an aggressive risk portfolio 100% invested in stocks, you should not judge your portfolio against the large cap S&P 500. A portfolio manager and risk strategy should be judged over a 3, 5 and 10 year period, not over a single year. If a manager can outperform its benchmark 3 out of 4 years with the appropriate risk, they are doing a good job relative to most fund and portfolio managers. Market conditions change during the economic cycle. No strategy can be designed to outperform in every market condition and year of the market cycle. Find a sound strategy and stick with it thru varying market conditions. It is not advisable to make any major changes to a strategy for one year of poor performance, because the market will change back to a normal year that your strategy will outperform again. Do not chase returns. Markets are unpredictable over short periods of time. Achieving goals based on a long-term plan is more important than maximizing returns. Also take into account portfolio management fees. If you are outperforming the benchmark by 2% per year before fees over the long-term and paying a 1% annual portfolio management fee, you can justify the cost. Also consider the other services you are getting from the portfolio manager as part of the fee. Your are paying the management fee for some or all of the following services: Asset allocation, equity selection, portfolio management, tactical market allocation to control risk, a wealth building plan, ongoing investment research, investor education, investment newsletter, behavior coach and portfolio performance reviews. The advantage of a good professional portfolio design is professional diversification, strategic asset allocation, enhanced security selection and discipline. Your portfolio is designed to meet your long-term retirement goals based on your risk tolerance and time horizon. Most investors find it difficult to implement and maintain an asset allocation strategy, reducing the likelihood of investment success on their own. Each quarter a portfolio manager should analyze the performance of the portfolio it manages and explain to the client why the portfolio performed better or worse than the benchmark. Changes should be made to the portfolio as needed. The appropriate asset allocation for your risk tolerance is most important. Risk adjusted return should also be considered in the evaluation. Beta, standard deviation and drawdown are used to measure risk. Of the 40 actively managed U.S. equity funds with Morningstar Analyst Ratings of Gold, 38 suffered at least one year of bottom-quartile performance in the past 10 years. Also compare the asset allocation and holdings of your portfolio to the benchmark it is trying to beat. In order to beat the benchmark, the investments must be better or the asset allocation must be different than the benchmark. A portfolio can beat its benchmark if the investments are superior and it is biased toward the outperforming asset classes. R-squared is a metric used to compare a portfolio s correlation to its benchmark s correlation. If R-squared is 100, it will likely perform at its benchmark. The largest contributor to a portfolio s performance is determined by the world stock markets. The second largest contributor to a portfolio s long-term performance relative to its benchmark is an optimal asset allocation. The third largest contributor to a portfolio s long-term performance relative to its benchmark is equity selection. 2014 was a difficult market for active portfolio management since most highly rated active mutual funds underperformed their passive ETF benchmark and many asset classes performed poorly. 15
The typical money manager underperforms the market averages by 2% annually because they use standard investment strategies like asset allocation, diversification and basic security selection. Their high management fees hurt performance. They spend most of their time looking for new customers and servicing current ones. The smaller your portfolio, the less time they spend managing it. Many money managers are dependent and have a closed architecture. They are pressured into selling high cost investments that benefit them and are limited to selling only sponsored funds. What does a higher annual return mean to you? If you invest in a high performing investment strategy that outperformed the S&P 500 by 5% annually, your returns projected over 25 years would have grown from $100,000 to $1,900,000. The Average investor would have seen their $100,000 grow to $260,000. This equates to outperforming the average investor by $1,640,000 over 25 years. Enhanced Strategy (5% > S&P 500) $ 1,900,000 13% annual return S&P 500 $ 634,000 8% annual return Average Equity Fund & Portfolio Manager $ 405,000 6% annual return Average Investor $ 260,000 4% annual return AAII Article 2016 (Top performing money managers (Strong 5-year, 10-year performance). By chasing performance, investors fall into an ongoing pattern of buying after share prices have risen considerably and selling after they have dropped. The top managers make up lost ground and add excess return following periods of weakness. Investors with the patience to stick with top managers through trying times are likely to reap greater rewards than those who chase the latest winner. Even the best investment managers see periods of underperformance with their strategy due to changes in market environment. Approximately 85% of top managers had at least one three-year period in which they underperformed their style benchmark by 1%, 50% by 3% and 25% by 5%. No strategy works all the time in all phases of the market cycle. Management or strategy changes can warrant selling of the fund. 16
Elections and the Stock Market How will the stock market react to the election results? The stock market does not like uncertainty, so the market may be volatile up until the election. Watch the stock market performance during the election year to see how it feels about leading candidates. The top issues of most recent elections have been healthcare costs, tax reform, immigration, terrorism & war, international trade, economic growth and help for the middle class. Most of the market gains in election years have been in the second half. The S&P 500 saw positive gains in most of the non-recession years since 1928. (InvesTech Research) It is unlikely we will see a recession in 2016. Which candidate will help economic growth and earnings grow again? How much power does a president have and how much damage can one person do? A lot will depend on which party gets in and the leadership in the house and senate, and the people they appoint. 17
Who was the worst president in the past 50 years and how did the stock market perform during their term? Secular Bear Market (1966 to 1982) Presidents: Johnson (D), Nixon (R), Ford (R), Carter (D) Fed Chairman: Martin and Burns in 1970. Vietnam war, Arab Oil Embargo, oil shock, Watergate, Nixon resigns, high inflation and 2 deep recessions. Election years in this period saw returns of 11%, 19%, 24% and 32%. The stock market saw no returns over this period. Secular Bull Market (1982 to 1999) Presidents: Reagan (R), Bush Sr. (R), B Clinton (D) Fed Chairman: Volcker and Greenspan in 1987. Black Monday 1987, oil collapse, Savings & Loan Crisis, Gulf War, Asia Currency Crisis, Russian Rubble Collapse, the formation of the Technology Bubble and one short recession. Election years in this period saw returns of 6%, 17%, 8% and 23%. The stock market saw strong returns over this period. Bill Clinton and Greenspan take some of the blame for the Tech Bubble. Secular Bear Market (2000 to 2008) Presidents: Bush Jr. (R) Fed Chairman: Greenspan and Bernanke in 2006. Collapse of the Tech Bubble, 911 Attack, Iraq War, Financial Crisis and 2 deep recessions. Election years in this period saw returns of -9% Recession, +11% and -37% recession. The stock market saw no returns over this period. George Bush Jr, and Alan Greenspan take some of the blame for the Financial Crisis. Secular Bull Market (2009 to 2016) Presidents: Obama (D) Fed Chairman: Bernanke and Yellen in 2014. Obamacare, Japan earthquake, fiscal cliff, Eurozone debt crisis and collapse of commodity prices. Election years in this period saw returns of 16% and??% in 2016. The stock market saw strong returns over this period. 18