Stocks: Looking Ahead

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    by Ryan P. Johnson CFA, CFP
    Director of Equity Research

    We recently completed our annual capital market assumptions update. What does that mean? At least once a year we look around the investment universe and envision what returns investors could expect over the next 5+ years. We do not take the approach that past performance should lead to similar future results; sometimes the opposite is true. For example, we do not love stocks today just because we have seen strong returns over the past 5 years, but we still think they have greater long-term return potential than bonds. We do expect stock market returns to be below average over the next 5+ years, but this does not mean we expect returns to be negative.

    Unemployment, Federal Reserve rates and valuation are a few important factors when estimating forward stock returns. Levels and trends both matter.

    When unemployment has fallen below 5% (level), this has not been an immediate concern as the U.S. economy has typically continued to improve. However, forward stock market returns have historically been below average:

    (With dividends reinvested into the index, the S&P 500 has returned 11.2% annualized from 1948-2016. Source: Bloomberg)

    Over the past two major cycles of the past 25 years (not including this cycle), the stock market peaked 2-3 years after the unemployment rate first fell below the 5% level. The market peaks were closer to (though not perfectly timed) when the unemployment rate moved above its own 12-month moving average (trend).

    When the Federal Reserve has been in a rate hiking mode (trend), this has usually been coincident with an improving economy and a rising stock market. Over the past two major cycles of the past 25 years (not including this cycle), the stock market peaked after the Fed stopped raising rates (level). The Fed and the futures markets still expect further rate hikes within the next year. A new unknown in this cycle is how the stock and bond markets will behave once the Fed starts to shrink its $4 Trillion balance sheet. The Fed is currently signaling a slowing of bond repurchases as current bonds mature, and it hopes to start this process later this year.

    Investing at higher valuations has historically led to lower forward returns. One of many valuation metrics is the price-to-earnings ratio, or P/E, which is the price of an asset relative to every dollar of earnings. Past earnings are also called trailing earnings; the current market price divided by past reported earnings equals trailing P/E. Right now, the trailing P/E on the S&P 500 is around 21.5 which is historically high (level). However, markets can remain overvalued or undervalued for long stretches (trend), and using valuation as a short-term timing indicator has typically not worked in the past.

    Based on a variety of factors and resources, we have concluded that “risk assets” such as stocks could generate average returns north of 6% annualized over the next 5-10 years, which is below long-term historical averages. Within your stock allocation, given what we feel are better return prospects, we would consider increasing international equities including emerging markets exposure. To reduce risk over the long term, we recommend regularly rebalancing your asset allocations to trim back equities if they’ve grown too large for your portfolio. Please feel free to contact us with any questions or concerns including a further discussion about our expectations for fixed income returns.