Embrace the Bear — and Trust Long-Term Returns

in Retirement Planning by

First came the “lost” decade. Then, after a brief respite – with two years of double-digit returns to end the last decade and begin the new one – new worries that yet another bear market looms.

If you’re like most investors, you react to this with a great deal of anguish and concern, nervously checking your account balances to see how big a bite the most recent market decline took from your nest egg. And for investors currently in retirement who are drawing down their portfolios, that concern is certainly understandable – it’s not easy to watch your primary source of income decline in value.

But if, like the vast majority of investors, your investment horizon is sufficiently long, and you’ll be adding to your retirement accounts for a decade or more, the possibility of yet another bear market is a much less dire proposition. Indeed, the reality is that it’s good news for your long-term prospects, because today’s market declines boost the market’s long-term expected returns; returns that will in turn inflate those nest eggs that have been leavened by years’ worth reliable contributions made through thick and thin.

Vanguard founder John Bogle has developed a wonderfully simple – but remarkably accurate – methodology for estimating future stock and bond returns. So let’s use that to take a look at what long-term returns look like currently.

  1. Dividend yield: The first component of the stock market’s return is its current dividend yield, which is now at 2.2 percent. This forms the base of the market’s future return.
  2. Corporate earnings growth: Over the long term, earnings have grown at an annual rate of approximately six percent per year, before inflation. Of course some years are higher, and some much lower, but the rate tends to revert to this long-term average over time. Add those two together, and we get an expected return of 8.2 percent over the coming decade from dividends and corporate earnings growth. Let’s call that the market’s economic return.
  3. P/E Ratio Change: The third component of the market’s total return comes from the annualized change in its price/earnings ratio, which represents what investors are willing to pay for a dollar of corporate earnings, and currently stands at about 14.

Today’s market declines boost the market’s long-term expected returns. This component represents the market’s emotional return, because it’s entirely dependent on investors’ fear and greed. In bearish environments – when seemingly no one wants to own stocks – the market’s P/E can plummet to the single digits. When the market is soaring and there’s no limit to investors’ appetite for stocks (as in the late-1990s) P/Es can soar to 30 or higher.

So what will the P/E be in ten years’ time? It’s a fool’s errand to speculate on something as ephemeral as investor emotions. But a fairly safe bet is to assume that the future P/E will end up near its long-term average, which is about 15.5.

If that’s true, and the P/E climbs from 14 to 15.5 over the course of a decade, it will add about one percentage point to the market’s economic return, bringing the total return to 9.2 percent – slightly above the market’s historical long-term return of 8 percent, and well above the low-single-digit returns that we’ve seen since 2000.

Bonds Paint A Pretty Clear Picture

But what make that number even more compelling is the long-term outlook for bonds.

Future bond returns are remarkably easy to predict, because they’re largely correlated to current yields. If interest rates rise, bond prices will fall, but that decline will be offset by reinvesting those coupon payments in new, higher-yielding bonds. If on the other hand rates fall, prices will rise. But that rise will be offset by the lower income produced by the newer bonds that you reinvest in.

Unless you’ve been living under a rock for the past few years, it won’t be news to you that interest rates are near historic lows. A portfolio of intermediate-term Treasury and highly-rated corporate bonds yields about 2.5 percent today, which provides a sound expectation for its ten-year return.

Given that, it appears as if today’s stock investors can expect a 6.5 percent annual premium as compensation for enduring the market’s volatility. And lest you think that’s not quite enough when the market’s falling by 400 points, consider that over ten years, such a premium would nearly double the size of your nest egg.

Owning stocks, as the past ten years have shown, is often no picnic. But the reason that so many millions of investors are willing to put up with the frustration and nerve-fraying volatility is because over the long-term stocks have historically well-compensated those who had the patience to keep their eye on the big picture. And the reality is that today’s market decline makes that long-term picture that much rosier.

So fear not the bear. Embrace it, knowing that a bear market today means a more secure retirement for you tomorrow.

 

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Contrarian Advisor

After spending decades in the financial services industry studying both investor behavior and the broad array of investment alternatives that they can choose from, the Contrarian Advisor is convinced that the surest route to long-term investment success is driven by simplicity and low costs.

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