If you think the next 10 years of investing will be like the previous ones and the same relationships between assets and strategies will work for your portfolio, then you don’t need to read any further. However, if you think the next 10 years could present major fundamental challenges for your portfolios, this article is for you.
Drastically different from the market timing approach, Asset Return Projection uses data on valuation, household and corporate balance sheets and other key macroeconomic fundamentals to understand the risks and likely returns of major asset classes. separate assets – equities, fixed income securities and precious metals. The research must be quantitatively rigorous and, also, qualitatively understandable and credible. From these asset return projections, we will determine baseline strategic asset allocations. It becomes the basis for asset allocation. Many choose to avoid or disbelieve in work and rely on a static allocation, typically 60% equities and 40% fixed income. We vehemently disagree and arrive at a much different solution.
Let’s start with everyone’s favorite asset class: stocks. Our stock forecasting process models positioning by investor type against historical levels. This positioning is highly correlated and statistically very significant for stock market returns over a decade. Essentially, it’s the most macro of all sentiment indicators: when everyone is interested in stocks, returns go down and vice versa. We also consider valuation levels relative to long-term averages. Currently, our models indicate that the equity market will provide a total return of only 2-4% (nominal) per year for the next 10 years! This is the lowest forecast produced by the model since 1999.
This forecast may seem unrealistic given the bear market we endured in the first and second quarters of this year, but we are confident in our models because we know full well that the bear market did not last long enough for investors to leave the market. And the investors who left came right back in May and June. We also engaged a new set of bullish investors via new trading platforms and they all bought stocks. Thank you Robin Hoodies. The valuation check shows stocks in the red zone; equities are expensive and particularly vulnerable to rising inflation and/or interest rates.
What the models don’t say is the possibility of creating massive alpha around this expected low index return. This is especially relevant now that so few stocks make up a disproportionately large percentage of public equity markets. To put that into perspective, the 6 largest tech stocks, called FAAMNG, are three times the size of the entire Russell 2000 Index, six times the size of the entire German market and seven times all stock exchanges in Germany. Latin America together. Investing in emerging markets, targeted real estate investing, or moving into smaller, more value-oriented stocks can be ways to provide the necessary alpha. In my last column (Venturing Outside the US Equity Markets – We Choose China), I mentioned China as one of the potential sources of equity alpha. We have other ideas in mind for future articles.
For the past 35 years, when stock markets were so expensive and over-allocated, Treasuries were the perfect complement. Falling stocks meant rising bonds. And, with hefty bond coupons before 2008, carry also helped. But this story is broken. Coupons are tight and if the Fed hits its inflation target, capital losses in the bond market could become severe. There’s no more free lunch with this combination of stocks and bonds.
On a yield basis, treasury bills will earn you 0.77% per year. With the Fed’s stance that negative nominal rates will not be tolerated, the prospect of Treasury bond capital appreciation during the next market correction is limited. The demise of the stock-bond relationship is already visible in European and Japanese government bond markets, as their yields remained relatively unchanged when markets corrected in March. Additionally, the real damage to wealth caused by inflation and federal taxes makes Treasuries a potential double loser.
Looking at stocks and bonds collectively as a traditional 60/40 balanced portfolio reveals the chilling truth that since 1900, a 60/40 portfolio has never been more expensive. With our two forecasts, we can expect the 60/40 portfolio to return 1-3% per year over the next 10 years. Given normal levels of volatility, we expect this portfolio to be mostly “return risk free”.
Our last major asset class is gold, which includes gold, gold mines and other precious metals. Our gold forecast model takes into account a wide range of economic measures, including consumption, investment, credit formation, money supply and interest rates. Our models suggest that we can expect gold to return 10-12% per year over the next ten years. In addition to statistical validation, this forecast adjusts qualitatively against our other asset class forecasts. The forces that have driven up stock and bond valuations are the same forces that, in turn, make gold relatively attractive and fundamentally cheap. Moreover, with global central bank printers in overdrive, the Fed abandoning its 2% inflation target, and Fed governors’ call for fiscal spending in the real economy, the foundations for higher inflation high are in place. On fiscal stimulus alone, the federal government has spent more than it has on the entire GFC during this crisis. The current federal deficit of 16% of GDP has only been surpassed during wartime in the history of the republic, but we still have more stimulus and “investments” to follow.
Finally, we maintain an allocation to our fourth and smallest asset class – uncorrelated alternatives. We use a combination of negatively correlated, uncorrelated and cash proxies strategies to generate returns greater than 0% regardless of stock, bond or gold market directions. Bitcoin is an example of a potential constituent of this asset class.
Putting all of these asset class forecasts together, our models suggest we should hold 25-35% equities, 20-25% fixed income, 25-35% gold, and 10-20% gold. uncorrelated alts. We leave some margin in the allocation to tactical changes and individual portfolio needs. In addition, the search is dynamic. The macro data is constantly changing, so the models are reviewed quarterly and of course the subsequent performance of the asset class also adds or subtracts from the expected return. It wouldn’t have been the optimal asset mix of the past two decades, but the world as we see it has changed dramatically, and the crystal ball is murkier than usual.