Looking forward, traditional investments are unlikely to produce attractive returns over the next decade. The days of investing in an S&P 500 index fund and closing your eyes and hoping for the best are over.
Stocks are expensive, and interest rates on 10-year Treasuries are near historic lows as well.
Frankly, neither stocks nor bonds are likely to offer investors attractive risk‐adjusted nominal or real returns over the next few years. (My model portfolio recommends alternative investments, some of which we’ll discuss below.)
Here’s why traditional investments are doomed to underperform, and why you should severely limit your exposure to them before the Super Crash.
And here’s what you should buy instead….
The Stock Market Has Reached Saturation Point
The stock market has been on life support for some time now, and it can’t keep up the appearance of vitality for much longer. Investors who continue to rely on a rising market courtesy of the kindness (or errors) of central bankers are likely to be very disappointed in the years ahead.
The S&P 500 enjoyed an enviable run since hitting its post‐crisis low in March 2009, more than tripling in value by mid‐2015. This performance was due to a strong recovery in corporate earnings from 2009 recession lows, as well as massive liquidity flowing into the market courtesy of the trillions of dollars of new money created out of thin air by the Federal Reserve and other global central banks. Stock buybacks were one of the primary sources of this liquidity – but like any shot in the arm, they only worked for a while and were paid for with huge borrowings that now weigh down corporate balance sheets.
Unfortunately, the Fed’s policies failed to create sustainable economic growth and reached the point of diminishing returns from an economic and market standpoint by the end of 2014. It is arguable that the post-crisis bull market ended when the Fed terminated its QE program in October 2014 – the “stealth bear market” I’ve discussed elsewhere.
Two of the most highly respected strategists in the investment world, Rob Arnott at Performance Analytics and Jeremy Grantham at Grantham Mayo van Otterloo (GMO), forecast low returns for stocks over the next 7-10 years. In fact, adjusted for inflation, they are projecting negative returns. As of December 31, 2015, GMO’s 7‐year real (i.e., inflation-adjusted) return forecasts was the following compared to the 6.5 percent long‐term historical return for U.S. equities:
U.S. Large Cap −1.8%
U.S. Small Cap 0.1%
U.S. High Quality 0.1%
International Large Cap 0.3%
International Small Cap −1.2%
Emerging Markets 4.0%
Performance Analytics had similar 10‐year real return projections as of mid-year 2015:
S&P 500 1.1%
Russell 2000 0.5%
MSCI EAFE (International) 5.3%
MSCI Emerging Markets 7.9%
Both firms forecast that only non‐U.S. equities are likely to generate meaningful returns over the next decade, and even those returns are relatively muted. And their projections for emerging markets will only materialize if the U.S. dollar weakens – if the dollar remains strong, emerging markets will do very poorly.
Since 2008, investors reluctantly but steadily increased their investments in risk assets like stocks, junk bonds, MLPS, venture capital, and real estate that are theoretically capable of providing higher returns. Unfortunately, however, you can’t eat theory. In fact, policies that drove interest rates down to zero effectively destroyed fixed income as a viable asset class and created a bubble in Internet, social media and biotech stocks while leaving the rest of the market overvalued. So now investors face years of low returns on risk assets because the Federal Reserve cannot suppress interest rates forever.
This Market Is Even More Overvalued Than It Looks
One issue that receives less attention than it should but points to the market being even more overvalued than it looks is that the quality of earnings has deteriorated in recent years as companies employ various accounting tricks to inflate their earnings. This subject receives virtually no attention from Wall Street analysts or the financial media because they want to paint a rosy picture to fit their political and business interests.
For example, companies increase their reported earnings by so‐called “non‐GAAP” adjustments that include non-recurring or non‐cash charges that distort cash earnings. Overall, 2015 S&P 500 GAAP (actual) earnings were $787 billion compared to $1.04 trillion of “pro forma” (non-GAAP) earnings. S&P 500 GAAP earnings actually fell by 12.7% in 2015 according to S&P Dow Jones Indices. Naturally, S&P 500 companies reported “pro forma” year-over-year earnings growth of 0.4%. But the GAAP figure was the worst since the 2008 financial crisis.
In addition, earnings are inflated by the massive stock buybacks I mentioned above and by artificially low interest rates. On a cash basis, most corporations are earning far less than their reported earnings.
To sum it all up, the stock market is overvalued and unlikely to generate high returns for years to come.
The outlook isn’t much brighter for bonds, either.
The Fed Has Completely Destroyed Bonds As An Investment Class
Bonds have been turned into “certificates of confiscation” by the Federal Reserve. The question that now must be asked is whether the confiscation of capital from savers will be permanent.
One key concept investors need to understand is the difference between “nominal” and “real” returns. Governments thrive on their citizens’ failure to understand this difference. “Nominal” returns are measured in constant dollars unadjusted for inflation. “Real” returns are measured in inflation‐adjusted dollars.
The U.S. government continues to promote the fiction that the prices of goods and services are falling when real world prices (other than energy since mid- 2014) actually are rising at double‐digit rates.
For this reason, investors need to earn at least high single digit returns on their capital to keep up with rising prices and the debauchment of their dollars by central banks; lower returns leave them with very low or even negative real or inflation‐adjusted returns, meaning their dollars buy less of what they need to live every year. The reason there is so much political discussion about low wage growth is that American workers keep falling behind in terms of what their paychecks buy them in the real world. No less is true with respect to their investment returns although this important point receives far little media attention.
For evidence of this, we need look no further than the performance of the two largest bond funds in the world.
For the 3-year period ended March 14, 2016, the PIMCO Total Return Fund generated annualized returns of 1.28 percent, while for the 3-year period ended Feb. 29th, the Vanguard Total Bond Fund generated annualized returns of 1.97%. On a nominal basis those returns are unimpressive enough, but on an inflation‐adjusted basis they are effectively zero. Today, the PIMCO Total Return Fund has lost about 50% of its managed assets since its peak of $2.04 trillion in 2013. While many have attributed these outflows to the departure of Bill Gross as the fund’s manager, the real reason is consistently poor performance that started well before Mr. Gross’s exit.
While these large bond funds sell themselves based on relative performance (i.e., how they perform against their peers), investors should tire of being told that “in the kingdom of the blind, the one‐eyed man is king.” They can’t eat relative real returns of zero. These returns stink and there is no reason for investors to pay to lose money, which is what they are doing when they invest in these funds.
While PIMCO’s and Vanguard’s returns reveal that these funds have been reduced to little more than glorified money market funds, they are actually much riskier than money market funds because they employ huge amounts of derivatives and leverage to earn these paltry returns. This means that their risk-adjusted returns are even worse than they appear and investors should be looking for alternatives. If these funds were half as adept at investing as they are at marketing, investors would have nothing to worry about. Then again, that could be said of most of the products sold by Wall Street.
The Future of Bond Returns Is Not Very Bright
Some highly regarded investors believe that interest rates will drop sharply over the next few years. Since they are already very low, interest rates would have to collapse to generate high returns. For example, it would require the yield on the 10-year Treasury to decline from 2% to 1% over 12 months to generate a total return of 12.8% (and 13.7% for 10-year zero coupon Treasuries). For the 30-year Treasury bond, a decline from 2.9% to 2.0% over a 12-month period would generate a 22.4% return (32.8% on 30-year zero coupon Treasuries). Such sharp declines in interest rates would almost certainly mean that the economy entered a recession (or worse) and that equities and other risk assets suffered severe, if not catastrophic, losses. Alternatively, only small jumps in interest rates would result in big losses for investors.
While I believe there is a reasonable likelihood that rates will move lower as the U.S. and global economy struggles in the years ahead, I believe the risk/reward with respect to high quality bonds (Treasuries, investment grade corporate, and municipal bonds) is poor. The most likely scenario is that bonds will continue to offer poor nominal and real (inflation adjusted) returns for a prolonged period of time in the best of circumstances and pose a serious risk of generating negative returns if central bank policies trigger higher inflation and higher interest rates. If central bankers have demonstrated anything, it is that they will double down on failed policies until they trigger a crisis. That crisis could manifest itself in higher inflation that will seriously hurt bond returns.
Here is the model portfolio I’ve recommended in my new book The Committee to Destroy the World:
- Gold, precious metals, tangible assets-10-20 percent
- Cash-10-20 percent
- Absolute return strategies-20-40 percent
- Dividend paying equities-20 percent
- Income generating securities-10-20 percent
You will notice that there is an allocation to “income generating securities” but not to bonds per se such as investment grade and municipal bonds and Treasuries. (Many absolute return strategies will also provide some bond exposure.) The types of investments that should be made to generate income directly are comprised of the following:
- Bank loans
- Closed-end mutual funds and mortgage REITs trading at a discount to NAV and paying high dividends
- Event-driven high yield bonds, bank loans, and convertible bonds.
- Bank preferred stocks
I’ll discuss these income-generating securities further in upcoming articles.
But beyond that, investors should minimize their bond exposure. Bonds have been destroyed by post-crisis central bank policies that have artificially suppressed interest rates around the world to zero (or less).
As for equities-by any reasonable measure, the overall stock market is extremely expensive today and the recent rally is most likely a bear market rally that will reverse before long. For that reason, it is prudent to limit portfolios to only 20 percent equity exposure until valuations improve markedly.