Returns on stocks and bonds have been quite impressive over the past 10 years ending September 30, 2019. In fact, stocks (as measured by the S&P 500 Index) have had a total return just over 13% per year, while the 10-year U.S. Treasury bond has had a total return of approximately 4% annually1. While it’s important to know what has happened, in investing we believe it’s more important to understand what might happen down the road. To get a sense of what returns may be over the next 10 years, investors can analyze a couple of key indicators.
For stocks, the cyclically adjusted price-earnings (CAPE) ratio can be used to estimate potential future returns. The CAPE ratio measures the price of the S&P 500 Index (adjusted for inflation) divided by the average of the past 10 years of the earnings of the index (also adjusted for inflation). The current CAPE ratio reading of 29.01 not only resides in the top decile of historical readings, but is only surpassed by readings preceding the great depression and the tech bubble. According to this metric, stocks are expensive from a historical perspective, but what does that mean for the next 10 years? Data shows that when stocks are trading in the top 10% of historical CAPE ratio valuations, the next 10 years returns have averaged 0.9% after inflation and have ranged from -6.1% to 5.8%2.
For bonds, investors can analyze the yield to maturity of the 10-year U.S. Treasury bond to get a sense of bond returns over the next decade. In fact, the current 10-year U.S. Treasury yield explains 91% of the return an investor will realize over the subsequent decade when holding a bond to maturity and reinvesting coupons at the prevailing rate3. With the current yield for 10-year U.S. Treasury debt sitting at 1.73%, one can project that bond returns over the next decade will be approximately 1.5% to 2%.
If these indicators are correct, returns for both stocks and bonds will likely produce low single digit returns over the next decade. Given these paltry projections, what should an investor do?
First, you must assess your asset allocation to make sure you are still in line with your investment goals. After all, while bonds are still an important diversifier in your portfolio, they are inherently more volatile when rates are this low. Also, while passive indexing strategies may have worked well over the past decade, it may now be time to seek an active manager who seeks to reduce volatility and exploit opportunities that others may miss.
At Karpus Investment Management, in our anticipation of lower returns and increased volatility we have reduced a portion of our equity exposure in favor of alternative investments, while finding short-term fixed income opportunities that offer attractive yields. If you are not sure of how your portfolio is positioned to address the potential for lower, longer-term returns, contact your financial professional to learn more.