Rational Return Expectations in Today’s Scary Financial Markets

With the roller coaster ride we’ve had so far this year, I decided to weigh in on what I see happening, with a look at the longer term. The S&P 500 stock index dropped 10.5% from January 1st to 1829, the low for the year, followed by the recovery to 2022 as of March 11th for a gain of 10.5%. Market sentiment went from dire to at least complacent, if not bullish, in the past few weeks.

I am not a short-term oriented investor, nor market timer, nor forecaster. But this volatility caused me to revisit my overall investment portfolio and long term plans. Any long term plan should make some assumptions about expected future asset class returns. In that regard, I ran across a very good article at Morningstar.

Here is a quick overview of some of the forecasts:

  • John Bogle – 6% annual nominal equity returns during the next decade; 3% bond return
  • GMO – Negative 2.1% U.S. Large-cap real returns during the next seven years; negative 0.9% real U.S. Bond returns
  • John Peters, Morningstar – 6-7% nominal (4-5% real) returns for S&P 500 over the next few decades
  • Matt Coffina, Morningstar – Equity returns no more than 6-8% over long run

There are several other forecasts with an average of much lower expected returns vs. the past 100+ years. Nominal stock returns since 1871 have been about 9%/yr. In the great bull market of 1982-2001 they were almost 14%/yr. The numbers above don’t look too bad, but I believe they may be too optimistic given where we are now. Why?

  • On an objective basis, using the Shiller P/E ratio on the S&P 500, the U.S. stock market is overvalued. Right now the Shiller P/E is about 25 vs. the historical median of 16. If earnings stay as they are (which would require no recession) and we moved back to the median, that’s a market drop of 36%. Markets often over correct, so a bigger drop is very possible.
  • Economic growth has been slow, and is showing signs of slowing further. Demographic trends weigh heavily on growth. In fact, there are arguments that demographics can dominate other factors. Take a look at this book and google this idea for other authors such as Harry Dent who say the same thing. Japan is living evidence.
  • Government and private debt worldwide is enormous, unsustainable and represents a cataclysmic threat to our financial system. U.S. Government debt is officially over $19 trillion. However, some estimates of future unfunded liabilities of social security, Medicare, Medicaid and other entitlements total over $127 trillion! The Federal Reserve has increased its balance sheet (aka money printing) from $900B in 2008 to almost $4.5 trillion.

I know, the government has run unfathomable deficits and racked up enormous debt for decades. Why should we care now or why should it make any difference? The answer is it cannot go on forever. At some point, the system will break.

Our dollar has been a safe haven for decades, but given that it is a fiat currency, no longer backed by tangible value (it used to be gold backed), there is increasing risk that this will end very badly. It may come in the form of a dollar crisis, leading to hyperinflation and enormous currency devaluation. If this happens, most financial assets will crash and the price of goods and services will skyrocket.

The other possibility is a default on the debt in which case we get deflation, depression, failing businesses and huge jumps in unemployment. Of course, there is a good chance that we continue “as is” but how long can we sustain this precarious position? Are you willing to bet on that and invest as though we are in normal times? Take a look at the “world leaders” (an ignominious distinction) on this chart, led by Japan and Greece.

Look at what’s happening in those two countries economically and you see a possible glimpse into our country’s future. We aren’t far behind, in 10th place. Our Presidential candidates make no mention of dealing with this, other than a few Republicans who have a plan to save Social Security, which is only part of the problem.

Bond yields are at historic lows, and even negative in some countries. Our brilliant Federal Reserve Board recently stated that they would also consider negative interest rates. You can google this and read many expert opinions but the evidence (see Japan) shows that it doesn’t work. It creates artificial financial bubbles in stock and bond markets, while punishing savers and discouraging corporate investment in productive real projects.

We are potentially at the precipice of a financial crisis greater than the Great Depression. The upshot is that I believe risks for investors are weighted heavily toward the downside. Here is another article by a noted investment manager saying the same thing. Whether you are near retirement or early in your career just beginning to save, my recommendation is to at least underweight your exposure to most stocks and to all but select bonds. Buy protective assets.  (I’ll talk about more specifics later). No one can predict the future and I certainly don’t profess to either. But the risk-reward trade-off now seems to be in favor of caution. In my opinion, we are in for a rocky ride over the next 5-10 years.

Check out these additional views. Although you might think they are extreme, there are some good arguments that should make you at least stop and think:





This is an interesting book that was written some time ago linking demographic trends to economies and markets, and forecasts the outlook ahead.