TSP Perspective: Expected Future Returns and Risks

I would like for you (and the friends I hope you share this with) to spend some time resetting your frame of reference for investing in the markets.  Many of you have a good feel for the market and can sense the market may be getting toppy.  For others, they see the market has been on a tear lately so they jump into equities with both feet.  For some they hear  bonds earn more than the money market, and stocks earn more than bonds and sometimes stocks go down but they always come back up if you buy and hold.  And the risk that you hear about on many financial conduits has more to do with rearranging the deck chairs on the titanic than ever considering getting into the life rafts.

Basic financial marketing does not help this last perception.  Take the TSP Lifecycle funds or any other retirement date targeted fund.  They simply adjust allocations to equities down as you get closer to retirement and bonds up.  Market exposure remains near 100% regardless of market conditions.   Or your “investment advisor” wants to know how “aggressive” or “conservative” you want to be so they can dial in an equity/bond mix based on your answers instead of market conditions and historical indications of future expected returns.

So I would like you to take a step back and establish a more historically anchored frame of reference on the equity markets.  By historically anchored, I do not mean 3 – 5 year past returns or even 10 year returns.  Instead, we need to examine some very solid predictive models that are highly correlated to expected future returns for equities looking forward the next 7 -10 years.  They certainly provide a much better mental and emotional anchor during market corrections.

I do track a few basic market valuation models for my service – not for timing purposes but for a better understanding of where we are in the market cycle and the potential risk in the market.  Usually I update these models monthly although quarterly would work just as well since they do not help with timing the market.  The effort keeps my perspective grounded in market history.  But today I am going to borrow from someone who spends more time perfecting these models and recently produced some charts worth taking a close look at.

Dr. John Hussman titled his 15 June weekly commentary “When You Look Back On This Moment in History” and in it he provides the basic warning that we know how the current bull market is going to end.  But I will add, the models do not predict when it will start and how it will unfold.   The most important take away from these models is not that they measure market valuations or are market crash indicators.  It is that they are highly predictive of determining the market’s future long term returns based on current economic and market measures. And this should be our investing frame of reference to make informed allocation decisions.

Dr. Hussman evaluates many “market valuation models” to include the bad ones (trailing P/E ratios, Price/Forward Earnings, the Federal Reserve’s model)  and the good ones (Shiller P/E, price/book value, Tobin’s Q, Market Cap to GDP, Price/Revenue) but in May he presented one that has a 92% correlation to future returns.  In his chart below, the dark blue line represents the ratio of the total US stock market’s capitalization divided by the total gross value added (similar to GDP) and the red line represents the market’s subsequent 10-year annual nominal total return.  The light blue comments are mine.

Expected Future Returns based on Market Capitalization / Gross Value Added

Expected Future Returns based on Market Capitalization / Gross Value Added

His highly correlated model tells us to expect a slightly negative return annualized over the next ten years for the TSP C fund (S&P 500 plus dividends).  If this sounds unbelievable to you today, consider if you invested near the market top from 1999 until 2002, your 10-year annualized return was less than 0% as seen in the chart.  While he does not mention this, notice at the 2007 market peak the 10 year expected annualized return also approached zero.  This requires the S&P 500 to be 38% lower by 2017 for the model to nail it unless we have a repeat of the 2000 stock market bubble deviation highlighted above.   A deviation does appear to be forming at the end of the red line, but as we saw in 2008 crash the markets can close the gap rapidly.

The following chart is another representation of future returns based on the Market Cap / Gross Value Added ratio also posted by Dr. Hussman.  Again I added comments in blue.  The chart would not have any plots to the right of the green line (where we are today) if it was not for the stock market bubble in 2000. In other words, the stock market bubble top is the only time the market valuations have been higher based on this and many other highly correlated models.   Also note that lower ratios (better valuations than today) have included annualized returns as low as negative 5% over 10 years.

Market Cap / Gross Value Added Scatter Chart

Market Cap / Gross Value Added Scatter Chart

Has your frame of reference for your funds’ returns or risk changed a little?  If not let’s focus on risk some more.  If history repeats, we know we are not going to simply see the market trade sideways for the next ten years and mark 0% annual returns.  The following warning and chart are again courtesy of Dr. Hussman’s 15 June 2015 commentary.

When you look back on this moment in history, remember that rich valuations had not only been associated with low subsequent market returns, but also with magnified risk of deep interim price losses over shorter horizons. The chart below plots valuations at each point in history against the deepest loss in the S&P 500 during the following five-year period. While there is more dispersion in outcomes, from the standpoint of deepest losses, the pattern should still be clear. The boundaries are shown by the orange lines. Current valuations are consistent with a market loss in the coming 5-year period between 40-60%. Nothing but blue sky above that range.

Again I added my point outs in blue.

Largest Losses in S&P 500 within 5 years

Largest Losses in S&P 500 within 5 years

The least drawdown when the ratio was above 1.8 was 35%.  We are currently near 2.0.  But we also see that the market has experienced a 55% loss when the ratio as low as only 1.7.  Today near 2.0 implies a greater than 40% loss is in our future (next five years) simply due to the fact the market cycles and we are far closer to a top than the middle of the cycle.

All of these charts simply hammer home the concept that richer valuations produce lower future returns and allow for deeper market corrections and bear markets.   Why the market cycles from high “valuations” to low “valuations” is complex.  Today, we simply need to understand it does and where we are in that cycle.  This establishes a better frame of reference for allocation decisions because it is precisely at market tops that recent past returns are the most misleading.  Chasing past returns invites the buy-the-dip or hold-the-dip mentality at a time we should be more concerned about the preservation of our nest egg.

Predicting what the annual returns this year or the next two years will be is much harder than predicting the long term annualized returns.  The growth of the economy, corporate earnings and the current interest rate are not as highly correlated to market returns as you would think.  As you set your allocations going forward, understand high equity allocations coupled with a buy and hold strategy even with a diversified allocation will NOT be a good strategy over the next decade unless losing a lot of sleep on your way back to breaking even appeals to you.

Unfortunately we cannot create an investment allocation model based on “market valuation” models.  Significant gains can occur for many years after the market becomes “over-valued”.  But when we approach the extremes it should be obvious that more caution is warranted and a historically proven strategy that adjusts for risk is needed.  Lifecycle funds and portfolio diversification do not take into account the only risk that counts – the increasing risk of large losses to your savings.

And if you believe bond funds or the TSP F fund is a place to weather the next storm, you may want to read The Last Hurrah.  In brief, the bond market has been in a longer bull market.  Interest rates have been trending down since 1982 and have recently hit new all-time lows.  The bulk of capital appreciation is behind the bond market and we are left with extremely low yields and risk of losses from rising interest rates.  The bond markets are also exposed to liquidity risk that simply means in a rising interest rate environment there may be NO buyers for periods of time due to declining bond prices. You would not lose as much as in equities, but the catalyst for the next stock market decline may be the popping of the bond bubble.

While the models presented do not tell you what is going to happen in the short run, market internals and measures of risk aversion do provide warning signs and signals for market tops.  These indicators show increased risk in the market today.  These indicators also will help us determine if the market can extend another year after a correction or if a market top is in.

I do track market internals and measures of risk aversion and provide bear market alerts for members along with timing signals for a historically proven risk-adjusted strategy.  If you do not already have a sound historically-proven strategy for riding the financial roller coaster, I hope you can join us or visit us at TSPsmart.com.