Markets have been firming up over the last couple weeks after one of the worst quarterly results since 2011. We all know that in the short term anything can and will happen. However it’s the long term results that really matter. Given the current situation, what are today’s data saying about our expectations for long term returns?
In the past, investors have relied on ideas such as the market’s price to earnings ratio or a country’s market cap to GDP ratio to forecast long term returns. The trouble with those measures is they haven’t been too good at actually forecasting the future. Using the price to earnings ratio only works about 50 percent of the time, while the market cap to GDP ratio works only 76 percent of the time. For example, according to the market cap to GDP ratio the US market has been “over-valued” since 1996. Following this indicator would have caused an investor to miss out on a 400 percent gain. I wrote in depth about the price earnings ratio back in Not all heroes wear CAPEs.
One of the reasons these earnings-based measures don’t work as well over long periods of time is the changing nature of profitability. As technology develops, businesses improve operations, become more efficient, and change the way an economy derives profit from its assets. There are plenty of other reasons we can cover in future notes.
With that in mind, I want to introduce you to a relatively new idea when it comes to understanding long term returns. I did not come up with this idea, but instead discovered it at Philosophical Economics. The method is simple to follow, and works about 91 percent of the time, far better than any other long term market valuation tool I’m aware of.
At its core, this new technique compares the total value of all equities to the total value of all debt. Its logic is purely contrarian: when the value of equities is low compared to that of debt, the subsequent ten year equity return is favourable. On the other hand, when the value of equities is high compared to debt, the subsequent ten year equity return can be negative. The chart below shows how well this measure has worked since the 1950s. You’ll notice the average amount of equity correlates very closely to the following ten year average return. This simple concept makes simple sense. It’s really just a mathematical expression of the old adage “buy low, sell high”.
So what’s the current reading telling us?
We can track the publicly available information from the Federal Reserve’s website here which is updated on a quarterly basis. The latest data from April 2015 suggest we should see an average return of about three to four percent per year over the next ten years. Historically, that puts us below the long term average of eight percent per year, but still offers a reasonable and positive return. The measure suggests we shouldn’t be concerned about negative long term returns until equities get much closer to 50 percent of the value of all assets, which is a very long way to go from here. So all in, things look rather average.
We should note that this valuation method has absolutely zero ability to understand short term returns, and that valuation ratios (even better ones) should not be used to time the market. Also, individual companies will produce very different results than the broad market over time. Great companies are still great companies regardless of what the market does.
While market timing is not recommended, this idea is certainly more useful in the financial planning realm where long term assumptions are more important. Many financial planners have been assuming long term market returns of about six to eight percent per year. This new approach suggests lowering those expectations may produce more realistic assumptions, and help guide a more successful plan for retirement and long term savers.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.