- Returns on a balanced portfolio of U.S. stocks and government bonds are likely to be negative over the next 10 years, underperforming those seen during the Great Depression.
- The housing bubble of 2007 and the 2000 tech bubble pale in comparison to the current policy-driven everything bubble.
- Based on the SP500’s payout-adjusted dividend yield, the market is priced to deliver total returns of -3.7% per year over the next decade.
- The collapse in bond yields on the back of the Fed’s purchases mean that bonds offer little to no insurance against a decline in equities and even a slight backup in yields can wipe out years of interest payments.
- We estimate that a 50:50 basket of the SP500 and 10-year Treasuries is set to return -1.5% in nominal terms over the next 10 years, below the returns seen following the 1929 peak. In real terms, returns are likely to be much lower.
Policymakers have taken extreme measures over recent years to support asset prices which will come at the expense of future returns as well as economic growth and financial stability. Returns on a balanced portfolio of U.S. stocks and government bonds are likely to be negative over the next 10 years, underperforming those seen during the Great Depression. In real terms, rising inflation will mean that real returns will likely be much worse.
Financial Wealth Is Detached From Reality
The record level of wealth that investors on aggregate believe they hold in part reflects the fact that valuation multiples are unsustainably high. Financial wealth tends to track nominal GDP over the long term, and as the chart below shows, it has diverged from the real economy to a record extent in recent years. The housing bubble of 2007 and the 2000 tech bubble pale in comparison to the current policy-driven everything bubble.
Source: Federal Reserve, BEA, Author’s calculations
Tesla is a great example of the major divergence between financial wealth as measured by asset prices and real wealth as measured by production and income capabilities. The company’s current market capitalisation is a staggering $263bn, representing roughly $700,000 per car produced. Absent an explosion in production and sales, it is highly likely that Tesla’s share prices will decline for years to come.
High Valuations Mean Weak Returns
There is an unwavering tendency for high equity valuations to result in weak future returns as valuations mean revert to long-term trends. Based on the SP500’s payout-adjusted dividend yield, the market is priced to deliver total returns of -3.7% per year over the next decade. Given the 2% dividend yield, this suggests that the index will be just over half of its current level in 2030.
Source: Robert Shiller, Bloomberg, Author’s calculations
This valuation metric adjusts the trailing dividend yield for the fact that dividend payments as a share of GDP are at all-time highs and assumes a steady mean reversion back to their long-term average. The reason we prefer this valuation metric is that it makes intuitive sense and has been highly correlated with subsequent returns as the chart above shows. The correlation between this valuation metric and subsequent returns has declined over the past decade as returns have been stronger than would have been expected based on previous valuations. However, this merely reflects the fact that valuations have risen to extreme levels. A similar pattern occurred in the late-1990s when equity returns in the run up to the bubble peak exceeded those predicted by valuations in the late-1980s. A decade of negative total returns was how this divergence resolved itself back then, and a similar fate awaits today.
Treasuries Now Represent Return-Free Risk
When stocks have undergone sharp declines in the past, government bonds have tended to perform well. This has been a result of interest rate cuts in response to economic weakness causing bond prices to rise, offsetting any losses from stocks. Furthermore, the high coupon payment on bonds have provided income offsetting any price losses in the event of falling bond prices. The following chart shows the total return performance of a 50:50 basket of the SP500 and 10-year Treasuries. Not only have returns been almost 10% annually since 1992, drawdowns have been minimal. Even with the large bear market losses following the dot com bust and the housing bust, rolling 5-year returns remained largely positive thanks to rising bond prices and coupon payments.
Source: Bloomberg, Author’s calculations
The problem now is that government bonds have gone from offering reasonable risk-free returns to reflecting return-free risk. The collapse in yields on the back of the Fed’s purchases has meant that bonds offer little to no insurance against a decline in equities and even a slight backup in yields can wipe out years of interest payments. As we saw during the height of the March equity market crash, bond prices actually sold off amid a rise in overseas sales showing that a balance equity-bond portfolio may no longer reduce drawdown risks.
10-Year Nominal Return Prospects Are Now Below Zero
We estimate that a 50:50 basket of the SP500 and 10-year Treasuries is set to return -1.5% in nominal terms over the next 10 years. This figure is simply calculated by taking an average of the SP500 returns implied by the payout-adjusted dividend yield and the yield on the 10-year bond, which, in the absence of a default, shows the returns that will result from holding to maturity. As the chart below shows, this is below the returns seen following the 1929 peak which of course gave way to the Great Depression.
Source: Robert Shiller, Author’s calculations
During the 1930s, real annual returns were bolstered by the fact that inflation was deeply negative, meaning that real returns were actually broadly in line with historical averages. This time around we expect inflation to result in significantly larger losses in real terms, with a 50:50 potentially even underperforming the returns seen in the stagflationary 1970s.
The problem with rising inflation is that even though it may provide some support to earnings and dividend payments, it also tends to undermine equity valuations as explained previously (see ‘SP500: Low Bond Yields Do Not Justify High Equity Valuations’). Rising inflation would likely have minimal positive impact on nominal returns while greatly undermining real returns.