Vanguard's Davis: What We Expect for Mar­ket Returns

Even given mud­dled eco­nomic growth expec­ta­tions in the devel­oped world, longer-term expected returns for stocks are not out­side of his­tor­i­cal norms.

Chris­tine Benz: Hi. I'm Chris­tine Benz for Morningstar.com.

I recently sat down with Joe Davis, chief econ­o­mist for the Van­guard Group. He dis­cussed his mar­ket out­look as well as his views on the economy.

Joe, thank you so much for being here.

Joe Davis: Thank you Chris­tine, pleasure.

Benz: You look at var­i­ous asset classes and attempt to come up with fore­casts for what they might return in the years ahead, and I under­stand that you've recently taken a look at U.S. equi­ties in par­tic­u­lar and ratch­eted down your expec­ta­tions a bit. Let's talk about, first how you arrive at those fore­casts, and sec­ond, what you're think­ing in terms of returns from the major asset classes?

Davis: So, in terms of how we approach the prob­lem here at Van­guard, [we're] very inter­ested in look­ing at what is a rea­son­able set or dis­tri­b­u­tion of returns for var­i­ous asset classes that you men­tioned. Again, a key point of dis­tinc­tion is, we are really focus­ing on a dis­tri­b­u­tion. It is not a point or one num­ber. But when we would look at that, one of the key dri­vers for equi­ties over long peri­ods of time, we tend to really focus on 10, 20, 30-year hori­zons, because that's where there is mod­est pre­dictabil­ity, and when we look at those hori­zons, val­u­a­tion metrics–P/E ratios, price-to-book, other measures–are a key fig­ure in that.

So, over the course of the past year or two, some of those longer-term expec­ta­tions have come down at the mar­gin, but they are still, more likely than not, closer to his­tory, the 1926-on expected return for equi­ties, as a cen­tral ten­dency, which can seem some­what coun­ter­in­tu­itive, when we hear and which I think is rea­son­able, some­what lower mud­dled eco­nomic growth in the devel­oped world going for­ward. And again, a key point that we tell investors is, much more impor­tant for long-term invest­ing is not the eco­nomic growth per se of what is expected. Much more impor­tant is the price one pays for growth. And just to push the anal­ogy, if it was only growth that mat­tered then say growth stocks would always out­per­form value stocks and that cer­tainly hasn't been the case over long peri­ods of time.

Benz: Right, right. So, with today as a start­ing point and look­ing at val­u­a­tions, what sort of range of returns might be real­is­tic for investors to look around?

Davis: So I think our range of returns, I mean, it depends how much con­fi­dent one wants to be in terms of mak­ing sure if one is in that range, to a be 100% con­fi­dent, you have a huge range.

When we are talk­ing about 25th to 75th per­centile, it's some­thing in the 4% to 12% range, which is still wide, but you know there is this nat­ural ques­tion of lower fixed-income yields, so hence lower expected returns, greater volatil­ity that we've seen recently in the mar­kets. So, the nat­ural ques­tion is, is the asset allo­ca­tion prob­lem, is it dif­fer­ent in some mean­ing­ful way?

I think we can talk about some of the shifts in the expected return fron­tier, but the fun­da­men­tal prop­er­ties of strate­gic asset allo­ca­tion, in our mind, have not changed–which means what? For a more con­ser­v­a­tive port­fo­lio, per­haps move into more aggres­sive, higher-expected risk, higher-expected return.

So, I think it's that trade-off that we have always had to grap­ple with as investors, and that's still inher­ent and expected going for­ward. So, I think, broadly speak­ing, we've taken a step back, how we approach the strate­gic asset allo­ca­tion prob­lem is unchanged for the fore­see­able future.

Benz: Now, is there any nuance in terms of your analy­sis among sub-asset classes, so inter­na­tional ver­sus U.S. for example?

Davis: So we will look at expected ranges of expected returns for U.S., other devel­oped mar­kets, and then emerg­ing mar­kets. And then on a strate­gic basis, although those cen­tral ten­den­cies can move around from month to month at the mar­gin, there is really no mean­ing­ful expected return dif­fer­ence between U.S. mar­kets and other devel­oped markets.

There is a slight expected return dif­fer­en­tial at the mar­gin for emerg­ing mar­kets, but again, that is in part because they antic­i­pate higher volatil­ity of an emerg­ing mar­ket port­fo­lio. So, there would be some expec­ta­tion for com­pen­sa­tion for that, but I wouldn’t call the dif­fer­ences in the cen­tral ten­den­cies as eco­nom­i­cally or sta­tis­ti­cally meaningful.

Benz: Okay. So, for fixed income, do you use cur­rent yields as sort of a proxy for what investors might expect from bonds in the future?

Davis: We do. Again, crit­i­cal to our analy­sis is that ini­tial con­di­tions do mat­ter, and for fixed income they are crit­i­cal as you men­tioned, Chris­tine. And we do look at what poten­tial evo­lu­tion of the yield curve is, as well as cor­po­rate spreads and other risk fac­tors in the bond mar­ket. But when you look at that, a yield-to-maturity on a bond port­fo­lio still remains to this day, all math aside, or all tools aside, it’s a rea­son­able return expec­ta­tion, cen­tral ten­dency for a bond port­fo­lio. So, I don’t think there is any get­ting around some of the bond math that we have lower expected returns given the fact that returns have been so stel­lar over the past two, three years.

Benz: And dri­ven by declin­ing rates, too.

Davis: Declin­ing rates. But again I think this one from a the­matic approach. I think in terms of investors, what we're going to con­tinue to hear are ques­tions around or just con­ver­sa­tions going around, where do I go for income? Is it still bonds? Yes, answers both fronts, but the return stream is just going to be lower. It could be more volatile at times, too, but I think this con­ver­sa­tion around div­i­dend yield pay­ing stocks ver­sus fixed income prob­a­bly will be more accen­tu­ated today and in the next two years than it has been prob­a­bly over the past decade.

Benz: So, another thing I want to touch on Joe: you and your team did some research where you looked at the per­for­mance of a bal­anced port­fo­lio dur­ing vary­ing eco­nomic con­di­tions, both reces­sion­ary and more expan­sion­ary, and I'd like you to tell us what you found, because I do think it’s pretty counterintuitive?

Davis: So, what we found is that on aver­age, the return on a bal­anced port­fo­lio, whether adjusted for infla­tion or not, has been effec­tively sim­i­lar or almost iden­ti­cal between peri­ods of reces­sion and expan­sion. As we all know, the U.S. econ­omy has been one or the other. And again that does seem very coun­ter­in­tu­itive. Part of that is because dur­ing reces­sions, what hap­pens in a bal­anced port­fo­lio? More often than not, there is a flight-to-quality effect for bonds, which can help off­set the ini­tial loses in equities.

The sec­ond effect, which is what I would call a lead­ing indi­ca­tor effect, the equity mar­ket is being one of those lead­ing indi­ca­tors, tends to fall, per­haps even into bear mar­ket ter­ri­tory long before it’s offi­cially rec­og­nized as a reces­sion, and then by exten­sion and by def­i­n­i­tion tends to rebound long before the reces­sion is offi­cially over, and this hap­pened as recently as early 2009, sev­eral months before the reces­sion offi­cially ended.

So, I think again, to my mind and our minds at Van­guard, it’s the tes­ta­ment to broader diver­si­fied long-term perspective–it’s not that one would wish that reces­sions occurs or that we’re indif­fer­ent as cit­i­zens that a reces­sion occurs, but it’s much more of why stay­ing the course and hav­ing a bal­anced long-term per­spec­tive is crit­i­cal. And I think this is just a great Exhibit A of why not pay­ing over-attention on near-term eco­nomic events can serve investors well.

Benz: For peo­ple right now, then, look­ing at, what seems to be per­haps a flat-lining economy, it seems that from this research peo­ple shouldn’t be overly con­cerned or inclined to be overly defen­sive at this juncture?

Davis: I would totally agree with this point, Chris­tine, but as you men­tioned, that could seem very coun­ter­in­tu­itive, and that’s I think under­stand­able given the infor­ma­tion that we just have to digest. I think that when you take a step back, you said very lit­tle if any growth. We have sim­i­lar expec­ta­tions in the near term. Now where are those expec­ta­tions com­ing from? We have found it most use­ful to look at what the finan­cial mar­kets themselves–the bond mar­ket, the stock market–what are the eco­nomic growth sce­nar­ios that those mar­kets are pric­ing in? And it’s by those mea­sures that give us some of these esti­mates of what a reces­sion are.

So, it’s a key point to keep in mind. So in other words, the mar­ket is already pric­ing in, so to speak, at a high level, very lit­tle or close to zero growth, which means then to react to, if one hears, we’re going to recession, have near-zero growth, I think then to react to one's port­fo­lio is again we would have to keep in mind that you are react­ing to the very mar­kets them­selves, to adjust to those mar­kets, that's some­thing that one wants to just think twice about before one proceeds.

Benz: You may be late with that.

Davis: Yes, late.

Benz: Thank you so much, Joe. This is really help­ful research. I appre­ci­ate you shar­ing with us.

Davis: Thank you, Chris­tine. My pleasure.

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