Beyond Diversification Series: Part One Continued

What is the secret to investor happiness? Lower your expectations. 

The stock market looks expensive. While we have had a good run from the bottom, earnings have not fully recovered from the COVID-19 shutdown. In this context, what kind of long-term return should you expect from your stock portfolio? There are many ways to answer this question, but let’s keep it simple. 

Jeremy Siegel, Wharton School of Finance professor and author of Stocks for the Long Run, often uses the inverse of the price-to-earnings (P/E) ratio as a back-of-the-envelope real return forecast for stocks. If we assume a P/E of 20, which is based on forward 12-month earnings,1 the expected real return (before inflation) for equities should be 5% (1/20).  

For inflation, we can use a market-implied or “break-even” estimate, as measured by the difference between the yield of a nominal bond and an inflation-linked bond.  Current 10-year inflation breakevens are around 2%.2 If we add inflation to the real return estimate, we get an expected nominal equity return of 7% (5% + 2%). Not bad. 

Now, here comes an approach for the pessimists. Robert Shiller, Yale professor and Nobel laureate, uses the cyclically adjusted P/E ratio, or “CAPE,” which is a P/E ratio that normalizes earnings over the last 10 years and adjusts for inflation. The 10-year period is meant to represent a full business cycle. If we invert the current CAPE,3 which is at 35, this approach yields a meager 2.86% expected real return for U.S. stocks. Let’s round that number up to 3% because, well, this is not an exact science, and I would rather err on the side of optimism. So, if we assume 2% inflation, we get 5% nominal returns.?  

If you’re saving for retirement, the difference between 5% and 7% could represent a gigantic gap in the total amount you may hope to accumulate by the time you reach age 65. It could mean the difference between a comfortable and not-so-comfortable retirement. 

What gives? The CAPE is higher than the forward 12-month P/E, in part, because earnings have increased significantly over the last 10 years. The key question is: Which “E” (Siegel’s or Shiller’s) do we think is more representative of future earnings?  

On this question, I lean on the side of the Siegel approach. Notably, accounting standards have changed over time, which biases current 10-year average earnings downward, and produces overly pessimistic CAPE forecasts. 

However, the CAPE has a very good track record. Historically, it has been a strong predictor of subsequent 10-year returns. Ignore it at your own peril??  

As much as we try to keep it simple, it is never easy to forecast returns. Here, two equally credible thought leaders disagree this time on the equity risk premium, a key input to many sophisticated return-forecasting models. Based on my experience, I suspect the Shiller and Siegel estimates represent bookends—from one of the most bearish to one of the most bullish forecasts. 

In my book, Beyond Diversification: What Every Investor Needs to Know About Asset Allocation (McGraw Hill, 2020), I recommend tilting the forecast toward Siegel’s estimate. A split of 80% Siegel and 20% Shiller seems reasonable to me, which gives us an expected nominal equity return of 6.6% = (0.8 x 7)% + (0.2 x 5)%. 

Some important caveats: This 6.6% forecast does not represent T. Rowe Price’s view (as a firm, we don’t have a “house view”) or the views of our Global Multi-Asset Division. It is just meant to be a simple and transparent forecast that uses a single factor, the P/E ratio. Further, the 80:20 blend is clearly my own finger-in-the air estimate and is definitely not “robust” from a quantitative perspective. But the bottom line is that if we want to forecast long-term returns, there is enough historical evidence to tell us that we should pay attention to valuation. It turns out that a very neat “trick” to do this is simply to invert the market’s P/E ratio. 

What about bonds? Well, if you think stocks look expensive, I have some bad news about bonds. In my book, I show that yield-to-maturity is a good estimate of long-term forward bond index returns. It works well, even if rates rise, decline, or remain stable, because over time, reinvestment effects tend to offset price shocks. As I write this article, the yield on the Barclays Aggregate is a meager 1.2%.? If you ask me for an expected return on bonds, say for the next five years, I think that is a good estimate. 

High valuations mean lower expected returns, especially when rates are near zero. Should you rethink your stock–bond mix? Stay tuned for more on this topic in my next LinkedIn article. One thing, however, is for sure: “the secret to happiness in life is to lower your expectations.” 

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1As of 02/09/21. Source: Bloomberg, EST P/E Nxt Y. 

2As of 02/09/21: 2.2%. Source: Bloomberg.

3As of 02/09/21. Source: multpl.com/shiller-pe. 

?For more on the Siegel-Shiller debate, see: “Jeremy Siegel versus Robert Shiller on Equity Valuations”, Advisor Perspectives, Robert Huebscher, 5/23/17, and “Jeremy Siegel’s predictions for 2018”, Advisor Perspectives, Robert Huebscher, 2/5/18.  

? The following article explains that the CAPE has a good track record, but that accounting standard changes weaken the model: Siegel, Jeremy J. 2016. "The Shiller CAPE Ratio: A New Look", Financial Analysts Journal, Volume 72, Number 3, pp. 41–50. 

?As of 02/08/21. Source: Bloomberg. 

Important Information 

The views contained herein are as of the date noted on the material. My views are my own and may differ from those of other T. Rowe Price investment professionals, portfolio managers and associates. 

T. Rowe Price Associates, Inc.