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In December 2008, the Federal Reserve embarked upon the most expansionary monetary policy in U.S. history. In an unprecedented action, the Fed moved its Federal Funds Target Rate to a range of 0% to 0.25% and began its first ever “Asset Purchase Program,” better known as Quantitative Easing (QE). At the time, these extraordinary measures were deemed “necessary” by most to save the world from financial “Armageddon” and prevent a second Great Depression.
Nearly two years later, in November 2010, the Economy was back in expansion mode (the official end of the recession was in June 2009) and financial conditions had stabilized. This would normally be around the time when the Federal Reserve would start talking about or initiating a tightening of monetary policy. However, this time the Fed had other intentions, as Ben Bernanke outlined in an op-ed that shocked the world.
In his November 2010 op-ed, Bernanke made the case for additional QE and an extended period of low interest rates. His justification was that such a policy would lead to:
(1) “Easier financial conditions”
(2) “Lower mortgage rates”
(3) “Lower corporate bond rates,” and
(4) “Higher stock prices”
Fast forward to today and what do we observe?
Financial conditions are near their loosest levels in history.
Mortgage rates hit historic lows and remain near their lowest levels in history.
Junk bond yields are at their lowest level in history.
U.S. stock prices are at all-time highs.
Whether you believe it was a result of their policies or not, it is difficult to argue with the notion that the Fed has largely achieved the objectives outlined in Mr. Bernanke’s November 2010 op-ed.
While this has undeniably been a boon for investors over the past five years, the question today is what achieving those objectives means for investors going forward. Judging by the record levels if bullish sentiment of late, investors seem to be assuming that the future will look very much like the recent past, but is this a valid assumption?
By forcing bond yields to all-time lows and increasing stock prices to all-time highs, has the Fed repealed the laws of valuation and mean reversion or simply pulled forward returns? Let’s take a look.
The 10-Year U.S. Treasury yield is currently at 2.4%. Historically, there has been a very close relationship between the beginning yield on the 10-Year Treasury and the forward returns from bonds funds. This is simple bond math; on average, the higher the beginning yield, the higher the return and vice versa. You can see this clearly in the chart below. While we don’t have enough history yet for yields below 3%, investors should expect returns to be well below anything they have seen in the past.
That is the critical issue investors are facing here. By maintaining interest rates at artificially low levels for over five and a half years, the Fed has effectively driven yields on nearly all fixed income products to historical lows. The reach for yield has entered the desperation phase in recent months as investors have grown tired of waiting for the Fed to raise interest rates.
From Treasuries to mortgage-backed securities to investment grade bonds to high yield bonds, yields on average have never been lower. The current yield on the iShares Core U.S. Aggregate Bond ETF (AGG), which is designed to approximate the total U.S. bond market, is 2.0%.
With this low starting level of yield, can investors really expect to achieve a nominal return from bonds of above 3-4% annualized over the next seven years? It is difficult to argue that they can. And this is assuming that interest rates could remain low going forward. As we saw in 2013, if interest rates rise from here, the actual returns are likely to be lower.
Moving on to stocks, we unfortunately observe a similar picture where forward returns have been pulled forward by Federal Reserve Policy. At a current cyclically adjusted P/E (CAPE) of 26 for the S&P 500, we are approaching the 90th percentile of historical valuations. There are few times in history where we have seen a higher valuation and none of these periods were favorable for equities going forward.
While not a short-term predictor, forward returns from CAPE levels above 26 have been significantly below average in the past. In the chart below, you’ll notice the strong relationship between beginning CAPE valuation and future returns. If we approximate the 90th percentile by taking a simple average of the 7-year annualized returns from the two top deciles of CAPE levels (4.8% and 2.5%), we come to a forward expected return of roughly 3.7% for U.S equities.
After five and a half years of unprecedented action, the Federal Reserve has largely achieved what they set out to do: namely inflate asset prices. We can debate whether this has actually led to a real economy “wealth effect” as they implied it would, but the historic rise in asset prices here is unquestionable.
That has certainly been great news for investors in their retirement years that are cashing out of investments at their highs. But for anyone not cashing out, it remains to be seen if this was indeed the best outcome. Mathematically, it would seem suboptimal to buy at elevated prices if you are adding additional funds to your retirement savings each year, as Warren Buffett has said in the past:
“If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.” – Warren Buffett
Buffett focuses on stocks, but a similar argument could be made for bonds, whereby forcing net savers to buy into bond funds at artificially low yields is likely to diminish long-term returns.
Much like the Fed-induced housing bubble that peaked in 2006, only those few homeowners who cashed out during the latter stages of the bubble actually benefitted from the bubble. Anyone else was hurt by it, either existing homeowner through rising property taxes (as taxes in most areas are based market values) or new homeowners who were forced to buy in at overvalued prices if they wanted to participate in the “American Dream.” We’ll leave the speculators buying five condos in Miami out of this but they of course suffered as well.
Thus, the problem facing most investors today is that the short-term gains that they have readily enjoyed in recent years have not been realized, and they also do not come without a price. There is no “free lunch” in the markets and the price to be paid from higher returns in the recent past is lower returns in the future.
The Federal Reserve, through five and half years of zero-interest rate policy and various rounds of quantitative easing, has effectively doomed the buy and hold investor to a period of low returns. With bond yields near historical lows and stock valuations near historical highs, it is difficult to argue otherwise for a typical buy and hold stock/bond portfolio in the coming years. In fact, a low single digit return would not be unprecedented given current yields and valuations.
Buy and hold is often touted as the best strategy for most investors. It hard disagree with this notion, as investors are notoriously poor market timers, with the behavioral tendency to buy high and sell low. That said, like any strategy, there are times when the market environment is more and less favorable to buy and hold. When prospective returns were high as they were in 2009, it was a great time to be a buy and hold investor. You want constant beta exposure when valuations are cheap.
But fast forward to today and we have an entirely different backdrop, where constant beta exposure is almost guaranteed to deliver below average long-term returns. In my view, such an environment is more favorable to active or tactical management, as was the case back in 2007. I am well aware of the derision that such strategies are facing today, as this has been one of the best periods for buy and hold in history. But this is precisely why they are more favorable going forward. No one wanted buy and hold in March 2009 and everyone wanted to be “tactical.” The opposite is true today.
1) The market can remain irrational longer than you can remain solvent.
This is one of the most overused and misused phrases in investment history. Solvency is not an issue in this analysis as I’m not writing about making an LTCM or Corzine type of bet. I’m also not suggesting that it is a good idea to short the market simply because it’s overvalued. There is a big difference between being cautious/defensive and being bearish/short. I’ve written extensively this year about how being defensive in 2014 has cost you nothing, with the two most defensive areas of the market, Utilities and long duration Treasuries, widely outpacing the average U.S. stock.
What I’m discussing here is asset allocation and for the majority of investors, who are not using short-term levered instruments, solvency is not a concern. What should be a concern for these investors is how the short-term irrationality going on today is going to lead to lower returns going forward.
2) But Jeremy Grantham says that the S&P 500 is going to 2250. Doesn’t that disprove your thesis?
While a long-term value investor, Grantham is one of the best promoters in history. There is a reason why his firm is managing over $100 billion. He knows that investors love forecasts and precise numbers and he is giving them exactly what they want. While 2250 target is making headlines, if you read the rest of the piece his projections are not far from my own, and may even be more cautious as he is arguing for negative real returns from a U.S. stock/bond portfolio over the next seven years. He is also suggesting that U.S. small caps may be at their most overvalued levels in history, with projected real returns of -5% per year over the next seven years. This is ingenious marketing as Grantham has put himself in a position where he cannot be wrong. If there is a bubble, his 2250 target will be easily hit and if there’s a bear market before that, well, he warned you that small caps were at extremely dangerous levels. Heads or tails and he wins.
But I digress. The 2250 forecast is a short-term forecast and the analysis here is focusing on longer-term returns. It is certainly possible for the market to continue to march higher in the coming months and I would note that Grantham’s forecast is only 13% above current market values. However, should it do so, that would only lower expected returns even more. Again, if you are not going to cash out on that rise but will be adding money to your 401k/IRA, shouldn’t you prefer a short-term decline back to more reasonable valuations over another late 1990’s bubble?
3) But the Federal Reserve is projected to keep interest rates low for at least another year. Won’t this cause even more of a reach for yield and higher bond prices?
It is certainly possible and I can only conclude that this must be the Federal Reserve’s objective by continuing with ZIRP after five years into a recovery and record low Junk bond yields. But again, is this the preferable outcome for a long-term investor that is continuing to add money to bond funds each month? Wouldn’t more normalized, market interest rates be more beneficial to most investors?
I would also note that investors are unlikely to wait to the very end of QE and ZIRP to begin making adjustments as I wrote about recently in “The Fed Prisoner’s Dilemma.”
4) This only talks about U.S. investments. Can investors boost long-term returns by moving abroad?
Yes. I have been making the case for much of this year that Emerging Market stocks and bonds are significantly cheaper and offer better prospective returns than the U.S. when looking out over the next seven years. The problem, though, is that most U.S. investors are unlikely to have enough exposure to these areas to make a difference to their portfolios due to home bias and recency bias. The other issue is that the interest rate suppression is a global phenomenon and while bonds in Emerging Markets are more attractive on a relative basis, yields are still historically low.
5) Can’t valuations remain high and yields low for the next seven years?
They could, but I would ask what probability you are assigning to that outcome and what your expected return from stocks and bonds would be in that scenario. If average bond yields are still 2.0% seven years from now, can you make the case that bond returns will be much higher than 2% in that scenario? Similarly, if the CAPE is at 26 seven years from now, can you make the case for strong equity returns based on earnings growth alone when nominal GDP is currently running at between 3-4%? The “permanently high plateau” theory has rarely been a good strategy for long-term investors.
5) What would change your outlook?
Buy and hold is not doomed forever. Markets are cyclical. Though it seems unlikely because we are conditioned by the recent past, there will be better valuations and higher yields in the future. If you are a long-term investor that is adding to your savings and investments each month, you should not fear this inevitability but should welcome it.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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