The Next 10 Years

We have a lot riding on the markets over the next 10 years. The return from stocks and bonds will determine if 78 million baby boomers accumulate enough money to retire and if Generation X (born between 1965 and 1980) will reach a standard of living enjoyed by previous generations. These answers will be contingent upon how well America competes in a sluggish global economy awash in government debt.

I am not a market guru, nor do I claim to be one. I’m just a 54-year old guy who has been in the financial industry for nearly half my life. Nonetheless, I do believe people need some guidance to plan for the future, and that’s what this analysis provides.

The following predictions about the next 10 years could be accurate or far off the mark. I don’t know. I believe my reasoning is sound and the methodology used for calculating return is logical and prudent. You’ll have to judge for yourself. Here are three of my thoughts:

  1. Continued austerity in Europe will keep pressure on global GDP growth. There will be more defaults, more volatility in the Euro, and more nations striving to reduce government spending in an attempt to alleviate debt burdens.
  2. A major banking crisis in Asia will likely develop that squeezes GDP growth in the region and rattles local demand. Real estate prices have escalated due to speculation from a new class of recently wealthy nationals. This has resulted in a glut of empty offices and apartments across Asia. China’s state banks have had to pump more money into projects because foreign investors are pulling out. The corporate debt-to-GDP ratio is at 110 percent, a perilous level.
  3. The U.S. will attempt to get our own fiscal house in order. This will require combined higher income taxes and cuts in entitlement growth. These measures will reduce GDP by about 1.0 percent annually on average. Change will come slowly at first, meaning high levels of government borrowing will continue. On the plus side, interest rates will remain very low, and a rebound in the housing market will stimulate job growth for young people where it is needed most.

Given this scenario, my estimate for U.S. GDP growth is 2.5 percent on average over the next 10 years. That’s not bad considering the mounting debt issues facing the world.

This won’t be steady growth, however. At least one major recession will likely occur, perhaps in contagion with an Asian banking crisis. I don’t believe the next recession will be as deep in the U.S. as in 2008 because the housing and banking industries have already gone through major restructuring.

What does all this mean for your investments?

  • Money market funds and cash equivalents (short-term certificates of deposit, T-bills) will yield below 1.0 percent for several more years, thereby generating a negative real return. The Federal Reserve will continue their low rate policy so that U.S. banks strengthen their balance sheets. Banks will be allowed to borrow from the Fed at near 0.0 percent interest and buy Treasury yielding 1.5 percent, thereby earning a risk-free return.
  • Bond funds will return much lower than their historic norm. Historically, investment grade bonds have earned about 1.5 percent over inflation. That won’t happen unless inflation drops to near zero percent.  The current interest rate on investment grade bonds, as measured by the Barclays Capital Aggregate Bond Market index is 2.0 percent. Investors should expect this to be the total return from a U.S. total bond market index fund over the next 10 years.
  • US stocks are likely to be the bright spot by earning 7.0 percent annually. Equity returns before valuation adjustments are a function of earnings growth (which have their root in GDP growth) and dividend yield including stock buybacks.  My 7.0 percent total return prediction for U.S. stocks assumes 2.0 percent inflation, 2.5 percent real GDP growth and a 2.7 percent all-on dividend factor, less 0.2 percent in index fund fees.

Multiple-expansion is always an unknown factor in predicting stock returns. The current price-to-earnings (P/E) multiple for the S&P 500 index is 14. This means investors are willing to pay $14 for every $1 in S&P 500 earnings. Multiple expansion occurs when stock prices move higher relative to earnings or when earnings move lower relative to price (as in a recession).

A sustainable increase in GDP growth tends to increase market valuation. During the 1990s, GDP growth had been running at 6.0 percent for much of the decade. Accordingly, the P/E multiple on the S&P 500 expanded from the mid-teens to well over 20 and hit 30 at its peak.

Unfortunately, the growth forecast for the U.S. is tepid compared to the 1990s. At 2.5 percent GDP growth, people are less willing to pay a high P/E for stocks. However, if we see an improvement in growth, then the market’s P/E could go higher. This may add about 1.0 percent annually or more to the return of the S&P 500 over the next 10 years.

Foreign funds continue to have a place in a well-managed, balanced portfolio. Foreign equity markets should return near U.S. markets, although Europe may have the best shot for outperforming because it has been beaten down due the Greece default and other weak Eurozone nations. Diversification is the best policy.

A discussion on market returns would not be complete without a mention of commodity prices. I’m not a fan of investing in commodities because it’s a negative cash-flow asset class. They cost money to own and pay no interest or dividends. Some people make money by price speculation, but that is hit or miss.

Today, many people are speculating that demand for natural resources will increase as China and other developing nations grow. I’m not in this camp. First, growth in emerging markets is slowing; and second, vast new supplies of every commodity are being exploited all around the globe. China is tapping into huge, previously unknown reserves of coal, copper, oil, gold and rare Earth elements in nearby Mongolia. The U.S. is finding oil and natural gas everywhere. There is so much natural gas coming out of the shale oil fields Texas that storage is a major issue. Over $1 million per day is being burned off because there’s no place to put it. Slower global growth and increased yields will keep commodity prices in check for several years.

Given the return numbers from stocks and bonds, assuming for a moment that my return numbers are in the ball park, how does this affect your portfolio? Investors who maintain a balanced portfolio of 60 percent in global equity index funds and 40 percent in fixed income index funds should see about a 5.0 percent annualized net of fees over 10 years. So, if you have $500,000 saved today, and save an additional $15,000 each year, a 5.0 percent annually in return grows your account to over $1 million in 10 years. That’s not bad!

Diversification, patience and discipline are three keys to achieving a winning portfolio over the next 10 years. Wise investors will create a diversified allocation of stocks and bonds based on their needs and rebalance their portfolio regularly to control risk.

Cost containment will also play a growing role in capturing your fair share of returns. Low-cost index funds and exchange-traded funds will continue to grow in popularity as more investors shed high cost actively managed products and the advisers who recommend them. Hire a low-fee investment adviser who specializes in these methods if needed.

And that’s the way I see it!