Tag Archives: Morningstar

Checking Up On Workhorse Bond Funds

At RIA Advisors, we do ongoing research on investments for managing client portfolios, of course. And we recently reassessed some popular bond funds. The results might be interesting for readers.

We looked at a group of bond funds that often make short lists for advisors – DoubleLine Total Return (DBLTX), DoubleLine Core Fixed Income (DBLFX), PIMCO Total Return (PTTRX), Baird Aggregate Bond (BAGIX), Dodge & Cox Income (DODIX), Western Asset Core Bond (WATFX), and Metropolitan West Total Return (MWTIX). We started with five year returns and Sharpe Ratios. That’s not a comprehensive analysis, but it’s where we began. Here’s what we found out.

DoubleLine Total Return’s 3.10% annualized return was the second best over the five years through January 2019, but that fund also had the best Sharpe Ratio of 1.16%. That means the fund delivered the best return per unit of volatility among this group of “usual suspects” on most advisors’ short lists. Lots of people think of the fund’s manager, Jeffrey Gundlach, as a gunslinger, who takes a lot of risks. That may be because of his outspoken and frank webcasts, which many investors, including the group here at RIA Advisors, find informative. But the truth is Gundlach runs risk-averse funds. When he’s done something unusual, such as his buying Alt-A mortgage-backed securities for the Total Return fund after the financial crisis, it’s been justified.

Those Alt-A’s probably delivered a ton of return in the first few years the fund owned them, so the fund’s gaudy post-crisis returns (more than 9% in each of the calendar years 2011 and 2012) might be a thing of the past. But that doesn’t mean the fund is any less attractive or that it can’t continue to beat most of its peers and the Bloomberg Barclays US Aggregate.

Western Asset has the best five-year annualized return at 3.44%. But its Sharpe Ratio of 0.92% shows that investors have to tolerate some volatility to achieve those returns. We also looked at how the funds – or the funds their current managers ran – did in 2008, and Western Asset had a difficult time in that stressful period. The firm went out on a limb at the wrong time.

PIMCO Total Return was the best performer in 2008, but those were the days when Bill Gross was at his peak. For the past five years, the fund looks more like the index in terms of its returns and volatility, but its new management team doesn’t own that entire record. Mark Kiesel, Scott Mather, and Mihir Worah have led the fund for a little more than 4 years, since September 26, 2014, and the fund’s 2.53% annualized return for the three years through January 2019 is better than those of most of its peers and than the index’s 1.95% annualized return.

Dodge and Cox Income was its usual solid self, with a 2.91% annualized return and a 0.90% Sharpe Ratio. During the crisis it lost 29 basis points, much better than the nearly 500 the average intermediate term bond fund lost, though behind the 5.24% return of the index.

Baird Aggregate has been solid as well. It has produced a 2.84% annualized return for the recent five-year period with a 0.76% Sharpe Ratio. In 2008, it dropped a little more than 2%, better than the category average, but worse than the index.

Finally, Metropolitan West has been lackluster. The fund has lagged the index with its 2.44% annualized return for the recent five-year period. However, it has surpassed the 2.25% return for the category average. The fund’s 0.67% Sharpe Ratio has surpassed those of both the index and the category average. So the fund has delivered better volatility adjusted returns than the index and category average. In fact, it’s Sharpe Ratio has also surpassed that of the PIMCO Total Return Fund.

Incidentally, it’s interesting to note how the Morningstar fund category average differed from the index in 2008 (-4.7% for the category average and 5.24% for the index) . That divergence results from the fact that the index is U.S. Treasury-heavy, and Treasuries did well in 2008. The average fund, however, often tries to beat the index by owning lots of corporate bonds or by taking other credit risk. And that was decidedly the wrong move in 2008, when the safest securities were the most loved.

There are other funds we could have included here such as PIMCO Income, Loomis Sayles Bond, Delaware Diversified Income, BlackRock Total Return, Guggenheim Total Return, JPMorgan Core plus Bond, and Lord Abbett Total Return but we had to make the cut somewhere for this article. We monitor those funds and others routinely, and so should other advisors who aren’t fully dedicated to passive funds.

Morningstar’s Christine Benz On Return Forecasts

Baseball Hall of Famer and sage, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” But, as Morningstar’s Christine Benz notes, plugging in a return forecast is necessary for financial planning. Without it, it’s impossible to know how much to save and for how long. In this spirit, Benz has collected asset class return forecasts from large institutional investors and Jack Bogle, who is virtually an institution himself.

Because the forecasts are longer term, they are worth contemplating even if you can’t take them to the bank. Nobody knows what the market will do this year or next year. But it’s at least possible to be smarter about longer term forecasts. When you start at historically high valuations for stocks, such as those that exist now, it’s reasonable to assume future 7- or 10-year returns might be lower than average. In fact, the S&P 500 has returned less than 5% annualized (in nominal terms) since 2000 when it had reached its most expensive level (on a Shiller PE basis) in history. That’s only half of it’s long term average.

Below are the forecasts in table form and in bar chart form as Benz reports them. Some are nominal, and some are real; we’ve indicated which kind after the name of the institution.

At least two of the asset managers’ forecasts — GMO and Research Affiliates — take the Shiller PE seriously. That metric indicates the current price of the S&P 500 relative to the underlying constituents’ past 10-year real average earnings. When that metric is low, higher returns have tended to result over the next decade. And when it has been high, low returns have tended to result. Currently the metric is over 28. It’s long term average is under 17.

Investors should take all forecasts with a grain of salt. But when valuations are as high as they are now, it seems prudent to lower expectations.

In The Market Carnage, One Long-Short Fund Looks Impressive

Some mutual funds short stocks (bet on them to go down) at least with part of their portfolios, and Morningstar has a long-short category with 248 of them. I ran a screen on Morningstar.com’s premium mutual fund screening tool to see which of them had lost 3% or less for the year-to-date period through December 24th and also had a five-star rating, meaning a fund’s volatility adjusted return put it at the top of the category over at least the last 3 years. For the year through December 24th, the S&P 500 Index dropped 10.36% including dividends.

My return criteria were admittedly arbitrary, but hopefully not unreasonable. If a long-short fund is down 5% when the market is down 10% in one period, has the fund failed? It’s not easy to say. But I wanted to be more stringent and see if any funds that had done well against each other for an extended period of time had also weathered the storm the market has delivered recently with a better than -5% return for the year.

First of all, 38 of 248 long-short funds (or only 15%) dropped 3% or less for the year. Also, the category average return was -9.14%, only slightly better than the index’s loss including dividends. That was a little disappointing; it’s unclear that the category is earning its keep.

The fund that made the grade, dropping 3% or less and posting a five-star rating was the PIMCO RAE Worldwide LongShort Plus (PWLIX) fund. The fund has been around since late 2014, and is subadvised by Robert Arnott’s firm Research Affiliates. Arnott and others are listed as portfolio managers.

This is not a typical long-short fund whereby a research team proceeds stock-by-stock, deciding what to buy and what to short on valuation or other factors. First, this funds gets its equity exposure (both long and short) through index-tracking equity derivatives which are collateralized with a bond portfolio. The fund tries to deliver positive returns with its equity exposures, of course, but also through its bond portfolio delivering a higher return than the cost of the derivatives.

Second, this fund is normally long a worldwide index of low volatility, high yielding, and low leverage stocks and short a worldwide capitalization weighted index where stocks are ranked according to the value the market accords them. Market capitalization indexes arguably create distortions, whereby the prices of the largest stocks are unduly elevated and those of the smallest stocks are unduly depressed. That means the combination of being long an index not based on market capitalization and shorting a capitalization weighted index can benefit an investor by owning relatively cheap stocks and shorting relatively expensive stocks.

Besides low volatility stocks outperforming capitalization weighted indices in long terms backtests, the fund can benefit from what it calls “dynamically managed global equity market beta.” In other words, the fund typically has more equity exposure when markets are less volatile and less when they’re more volatile. The fund’s literature argues that these three sources of return – the low volatility equity income strategy, the actively managed absolute return bond strategy, and the dynamically managed global equity market beta strategy – are uncorrelated.

It’s likely that the correlation argument is true. After all, the low volatility equity income strategy is similar to a value approach to stock investing. The low volatility strategy was devised by a finance professor named Robert Haugen who studied the works of Benjamin Graham and took issue with the assertion of modern academic finance that one had to incur high volatility to achieve a superior return. Haugen showed that high volatility stocks were mostly what Graham called the “glamour” stocks that ran hard for a while, but wound up flaming out. Lower volatility, boring companies that didn’t capture investors’ imaginations (and then disappoint them by not fulfilling extreme expectations) plugged along and eventually produced superior returns.

The dynamically managed global market beta strategy, however, is a kind of momentum strategy. If it’s adding exposure when market are calm, it’s likely adding  exposure when they’re going up – or at least not declining and vice versa.

So the two equity strategies fight against each other to some extent – or complement each other, depending on how you look at it. One potential problem is if low volatility equity income strategies are much in favor now and, therefore, become so expensive that they don’t have much return potential over market capitalization strategies. Then the investor is dependent on the momentum-like dynamically managed beta strategy and the bonds outstripping the cost of the derivatives for return.

But maybe relying on two strategies isn’t so bad. And the fund has acquitted itself well, producing a 7.84% annualized return for the 3-year period through December 24th, 2018. That’s better than the S&P 500 Index’s 6.65% return and amounts to a performance good enough to land the fund in the top percentile of the Morningstar long-short fund category over that stretch. The fund has achieved that superior return with lower volatility — a 6.82% standard deviation of returns compared to a 9.4% standard deviation of returns for the index.

The comparison to the S&P 500 Index — the typical way Morningstar displays returns for long-short funds on its website — may work too much in the fund’s favor lately since shorting international stocks has undoubtedly helped it. But the fund has also been long international low volatility stocks, and, overall, it’s been easier to beat a global index lately than a domestic one. three years is also not a very long period of time, but we don’t have much more history on this fund. Investors will have to make due with that for now in their analyses.

Finally, while the institutional share class’s 1.28% expense ratio isn’t cheap by plain equity fund standards, it is compared to long-short funds, where shorting stocks, which can entail paying dividends, can get expensive in a hurry.

Altogether investors have a long-short option worthy of consideration in this fund, which has the potential to beat the index simply and provide an uncorrelated source of returns in a portfolio.

The Tale Of The Two Bond Kings

(This article originally appeared in Citywire.)

Back in September, I examined the records of the managers that Morningstar nominated as candidates for ‘domestic equity Manager of the Decade’ in 2009. The results were not hugely encouraging. After making that illustrious shortlist, not one manager went on to beat their best-fit index. The Yacktman fund came closest, gliding so smoothly to its 11.43% annualized return from 2010 through August 2018 that it nearly produced the same Sharpe ratio as the S&P 500 index (1.14 versus 1.15 over the past decade). However, it still trailed the index’s return by more than 2.5 percentage points annualized.

Now, though, it’s time to focus on the nominees for the fixed income ‘Manager of the Decade’ award. The results are decidedly better. In 2009, Morningstar shortlisted Dan FussJeffrey GundlachBill Gross, Christine Thompson of Fidelity’s municipal bond funds, and the team on the Dodge & Cox Income fund. The award ultimately went to Gross, but it turns out that he is the only one to have subsequently posted a poor set of results.

It is unclear why Morningstar’s fixed income nominees have fared better than its equity picks. Perhaps, given the relative illiquidity of the bond market, it’s simply easier for fixed income managers to beat their indices than it is for their equity counterparts. Or maybe manager selectors and consultants have an easier job when it comes to identifying talented bond managers. Whatever the explanation, the fund analysts at Morningstar (including me, at the time) certainly seem to have been more successful in having their bond ‘Manager of the Decade’ nominees go on to post good returns in the future.

Masters of their domains

First up is Christine Thompson, who headed Fidelity’s municipal bond operation at the time of the nominations. She is no longer listed as a manager of Fidelity’s funds, but it was obvious that Fidelity’s municipal bond operation had depth and that this was a team nomination. For the period from 2010 through the end of September 2018, the Fidelity Municipal Income fund has posted a 43.7% cumulative return, while the Bloomberg Barclays Municipal Bond index has delivered 39.9% (see Figure 1). Over the past decade, the fund’s 1.09 Sharpe ratio has trailed that of the index (1.13), meaning that it has incurred more volatility to achieve its outperformance. Even so, it would be difficult to say that the fund has carried an unjustifiably high level of volatility.

Next, we have the ‘bond kings,’ Bill Gross and Jeffrey Gundlach, and the Dodge & Cox Income fund. All three deserve to be judged against the Bloomberg Barclays US Aggregate Bond index. There are two caveats with our data here. Gundlach left the TCW Total Return fund in December 2009 and began managing the DoubleLine Total Return fund the following April. Here, I have taken the TCW fund’s 2010 data through April and then hooked it up to DoubleLine’s data starting on May 1 that year. Similarly, for Bill Gross, I took the Pimco Total Return fund’s data from 2010 through October 2014 and then picked up with Gross’s new charge, the Janus Global Unconstrained fund, in November 2014. Gross began his tenure at Janus on October 6, 2014.

No Undue Risk

Realistically, Gundlach has dominated the period since the ‘Manager of the Decade’ nominations. According to the spliced data, he posted a 58.9% cumulative return from 2010 through the end of September 2018. His combination of safe Ginnie Mae bonds and beaten-up, high-yielding Alt-A private label mortgage-backed bonds has worked splendidly.

The team of managers that runs the Dodge & Cox Income fund has acquitted itself well too, delivering a cumulative return of 39.6% versus the index’s 30.7%. Gross, by contrast, has returned just 29.4% over that period (see Figure 2).

And lest anyone suppose that it was reckless portfolio positioning that accidentally produced Gundlach’s heady post-crisis returns, let the record show that he hunkered down with higher quality securities exactly when he should have done in 2008. That year, he piloted the TCW Total Return fund to a top-decile performance in the Morningstar intermediate-term bond fund category, with a 1.09% return.

Finally, the Loomis Sayles Bond fund, led by Dan Fuss, has outpaced the index with a cumulative return of 65.1% versus the Agg’s 30.7% (see Figure 3). However, investors should take this with a pinch of salt. The fund routinely invests in junk bonds and emerging market debt, along with a slug in safer sovereign debt. That makes it more volatile. Indeed, its Sharpe ratio over the past decade through September 2018 is 0.84. Compared with the Agg’s 1.04 Sharpe ratio over the same period, the Loomis Sayles Bond fund arguably hasn’t achieved as attractive a volatility-adjusted return.

Overall, the Morningstar ‘Manager of the Decade’ nominees in fixed income have produced solid results since 2009. Consultants often think small-cap stocks and international markets afford greater opportunities for active management to shine. Perhaps the ability fixed income provides has been under-appreciated.

The October Curse: Who Survived & Who Didn’t

October is finally over.

The S&P 500 Index dropped 6.84%, including dividends in a showing that was a rude awakening for investors who had, once again, become complacent. The beginning of this year was marked by a surge in January following a year in which the index didn’t drop for a single month. But after February and March wiped out January’s gains, rattled investors relaxed once again. Now that everyone’s on high alert again, it’s a decent time to see which stocks and sectors held up for the month. Keep in mind that our numbers are 1-month returns through October 30th, according to Morningstar, and stocks rallied on the 31st.

First, as we look at the top positions of the S&P 500 Index, it’s striking how many companies are technology or financial services companies, according to Morningstar’s classification. It seems like that’s what our economy consists of now – wealthy people checking their investment accounts on iPhones and less-than-wealthy people doing other things on cheaper phones.

In any case, the month wasn’t kind to FAANG stocks. Although Apple held up with a -5.5% showing through Oct. 30th, Amazon dropped more than 20%. Facebook dropped more than 10% and Alphabet more than 13%. Although not a top-15 index position, Netflix dropped more than 20% for the month through Oct. 30th.

The clear winners were healthcare stocks. Johnson & Johnson gained nearly 2%, making it the only top-15 constituent to post a positive return. Another pharmaceutical firm, Pfizer, and health insurance giant, UnitedHealth Group (UNH), managed to keep their losses to less than 3% each.

Financial services had a mixed showing. Berkshire Hathaway dropped less than 5%, as did JP Morgan Chase. But Bank of America shed 9%, and Visa dropped nearly 12%.

Defensive Sectors And Healthcare Shine

Since we can’t get a good cross-section of sectors by looking at the top-15 constituents of the index, let’s move to the sectors themselves as represented by ETFs. Here the returns will be on a 1-month basis through Oct 30th. It turns out the defensive sectors that pay dividends held up.The SPDR Utilities Select Sector SPDR ETF (XLU) posted a 1.98% 1-month gain. Similarly, the iShares Cohen & Steers REIT ETF (ICF) dropped 1.47%. The Consumer Staples Select Sector SPDR ETF (XLP) posted a 2% 1-month gain, while the iShares. U.S. Financials ETF (IYF) lost around 5%. The iShares U.S. Healthcare ETF (IYH) lost a little more than 7%.

The more negative sectors were consumer discretionary, industrials, energy, and materials. Consumer Discretionary Select Sector SPDR ETF posted an 11.24% 1-month loss. The iShares U.S. Industrials ETF dropped nearly 11%, while the iShares U.S. Energy ETF dropped around 12% for the month. The Materials Select SPDR ETF dropped around 9%.

Bonds Didn’t Rally

On the bond side, short-term U.S. Treasuries did fine, but didn’t experience the rally that sometimes goes with a plunging stock market. The iShares Short Treasury ETF (SHV) gained 0.16% for the 1-month period through Oct. 30th. Treasuries with longer duration struggled, however. The iShares 10-20 year Treasury Bond ETF (TLH) lost around 1% for the 1-month period.

Intermediate investment grade corporates also struggled. The iShares Investment grade Corporate Bond ETF (LQD) dropped around 1.8% for the 1-month period. High yield or junk bonds didn’t do worse, however, with the iShares High Yield Corporate Bond ETF (HYG) also dropping 1.8%.

Municipals held up fine too, but, like Treasuries, didn’t rally either. The iShares Short Maturity Municipal Bond ETF (MEAR) gained 0.03%, while the iShares National Muni Bond ETF (MUB), with an average maturity of more than 6 years, dropped 0.39%.

The worst performing bonds were emerging markets dollar-denominated government bonds. The J.P. Morgan USD Emerging Markets Bond ETF (EMB) lost 2.52% for the 1-month period. By contrast, the iShares J.P. Morgan EM Local Currency Bond ETF (LEMB) gained 0.51% for the 1-month period. The discrepancy of the returns in these two funds shows the effects of the U.S. dollar which continued to strengthen. When emerging markets countries have to pay debt in dollars, it hurts them when the U.S. dollar rises against other currencies.

One is tempted to say that the absence of a Treasury rally might mean a new normal for interest rates. But a still-flat yield curve makes it difficult to be certain of that outcome.

Volatility Is The Price Of Admission To Financial Markets

If it feels to you as if volatility has returned to the stock market, you’re right. But, although we’ve had a bad month in October so far with a nearly 10% loss in U.S. stocks, the calm we’ve had over the past few years is more unusual. And that makes this volatility feel worse than it should.

Garden Variety Correction

Here are a few statistical facts that should put the recent volatility into perspective. First, the S&P 500 Index was up around 11% for the year at its recent peak, including dividends. Now, through Wednesday, October 24th, it’s up 0.88% for the year. That means we’ve had a garden variety correction of around 10% so far. A bear market would be a decline of 20% from the market peak, and that would mean stocks would have to drop around another 10% from here to achieve that. It’s possible that will happen, but, even if it does, we’re only halfway there at this point.

And if we do enter a bear market, that won’t be so unusual either. We haven’t had one since the financial crisis and recession of 2008, after all, and this is now the longest running bull market in history. In fact, the length of the bull market, which started in March of 2009, is what makes any volatility feel unusual – even an ordinary 10% correction.

Calm Creates Complacency

Another important statistic that makes this correction feel unusual is that the S&P 500 Index didn’t drop in a single month in 2017 as it posted a nearly 22% return for the year. That was the first time in history the index didn’t record a negative month in a calendar year, and periods marked by such calm, especially if they come during  the longest bull market in history, make investors complacent.

There is a tendency for investors to feel invulnerable after such periods, even though that kind of calm should make investors nervous about when the next bout of volatility will arrive. The human mind doesn’t work that way though. Behavioral economics has shown that we have a strong tendency toward “recency bias,” meaning we extrapolate whatever hash happened in the recent past onto the future. That often makes us nervous when we should be calm and a little too calm when we should be a little nervous.

It’s true that at the beginning of this year volatility arrived again in February and March when the stock market gave up the roughly 10% gain it achieved during the first few weeks of January. But then calm ensued, and the market marched up nearly uninterrupted to match its earlier gain from January. By the beginning of October, complacency and recency bias had set in again.

Bonds Bring Ballast

Consider also that bonds have done their job by holding steady and bringing ballast to portfolios while stocks have dropped. The Bloomberg Barclay’s U.S. Aggregate Index is down 0.55% for the month of October. It’s true that you might expect bonds to be up a little for the month. It often happens that stock market declines cause a rally in investment grade corporate and especially government bonds, so a slight decline in the main bond index is a little unusual. But it’s nothing extreme, and having a part of your portfolio so stable when the stock market is declining can be a blessing.

This leads us to consider a balanced portfolio, which usually consists of 60% stocks and 40% bonds. This classic allocation has served generations of investors well with its moderate risk/reward profile, and it happens that a domestic index balanced portfolio is down a little less than 1% for the year through October 24th. A global balanced portfolio is down more – around 4%. But that’s not catastrophic either.

Also, the historical “standard deviation” or volatility of a moderate or balanced allocation has been around 10%. That means investors can expect a range of returns within 10 percentage points in either direction around such a portfolio’s average return of 7% per year. So far, we are within that tolerance. And standard deviation isn’t perfect; it only captures most of the deviations around the average return, not all of them. There are times when balanced portfolios will have a wider range of return including losses than a 10 percentage point deviation around the average return. But we are nowhere near these larger losses yet.

Here, again, investors may be fooled by recency bias. Morningstar’s moderate allocation category has delivered a standard deviation of over 9% for 15 years, but only around 6% or one-third less for 3 years.

 

Overall, investors should remember that although October has been a bad month, the volatility we’ve experienced over the past few years is well below average. October has been a reminder that volatility is part of the “price of admission” to the financial markets.

You Are Different This Time

You don’t always see a respected member of the financial commentariat argue that it’s different this time. But that’s almost what Morningstar’s Christine Benz has done in an excellent recent article.

What Benz means is that you’re different now than you were during past market cycles. More specifically, you’re older now than you were during the last market debacle, so you have less time to recover from another one if it should occur. That might not mean much if you were 10 in 2008 and 20 now. But it means a lot if you were, say, 50 in 2008 and 60 now or even 45 in 2008 and 55 now. If you’re five to 10 years from retirement, the risk of encountering a period when bonds outperform stocks is high enough – and dangerous enough to your retirement plans — so that you should reduce stock exposure.

The Math Is Different in Distribution

And, if you’re retired and withdrawing from your portfolio, the “sequence-of-return” risk – the problem of the early years of withdrawals coinciding with a declining portfolio – can upend your entire retirement. That’s because a portfolio in distribution that experiences severe declines at the beginning of the distribution phase, cannot recover when the stock market finally rebounds. Because of the distributions, there is less money in the portfolio to benefit from stock gains when they eventually materialize again.

I showed that risk in a previous article where I created the following chart representing three hypothetical portfolios using the “4% rule” (withdrawing 4% of the portfolio the first year of retirement and increasing that withdrawal dollar value by 4% every year thereafter). I cherry-picked the initial year of retirement, of course (2000), so that my graphic represents a kind of worst case, or at least a very bad case, scenario. But investors close to retirement should keep that in mind because current stock prices are historically high and bond yields are historically low. That means the prospects for big investment returns over the next decade are dim and that increasing stock exposure could be detrimental to retirement plans once again. In my example, decreasing stock exposure benefits the portfolio in distribution phase, and that could be the case for retirees now.

 

 

 

The Psychology Is Different In Distribution

But it isn’t just that stock prices are high and that bond yields are low now. Benz argues that your mindset is likely different too. “Even if you sailed through the 2007-2009 market meltdown without undue worry or panic-selling, the next downturn could prove more visceral if retirement is closer at hand and starting to seem like a realistic possibility. It’s not fun to see your portfolio drop from $500,000 to $225,000 when you’re 45. But it’s way worse to see your $1 million portfolio drop to $500,000 when you’re 55 and beginning to think serious thoughts about the when and how of your retirement. The losses are the same (in percentage terms); the ages are different.” In other words, your proximity to retirement could make you sell at the bottom more than it might have a decade ago.

Sure, everyone probably needs some stocks in their portfolio in retirement. Returns from cash and bonds may not keep up with inflation, after all. But stock returns might fall short too. And if stocks do lag, they probably won’t do so with the limited volatility that bonds tend to deliver, barring a serious bout of inflation. So, if you’re within a decade of retirement, it may be time to think hard about how much stock exposure is enough. The answer might be less than you think for a portfolio in distribution phase.

A Recession Says Nothing About Future Stock Returns

(Thanks to Morningstar’s John Rekenthaler for including one of my emails to him in a column consisting of reader reponses while he tended to his wife who, as he reports, suffered a fainting spell. We wish both of them well, of course.)

Do we need a recession or another credit event similar to 2008 to tell us stocks are overpriced and cause them to tumble? John Rekenthaler of Morningstar seems to think so. I sent him an email in response to an article he wrote doubting the verdict of recent bubble-callers like GMO and Research Affiliates. I said stocks were objectively expensive (using the Shiller PE), and that meant future returns would likely be low.

But John thinks that a turn in the economic cycle will determine a downturn in the stock market, and tell us, after the fact, if stocks are overpriced. Since we don’t know when that will occur or what it will look like, we must remain agnostic as to the future returns of the stock market. As he responds to my email in a new article:

“One of these years the economic cycle will turn, thereby making projected corporate earnings wildly overstated rather than moderately so. Stocks will get crushed. If that happens in 2018 or 2019, then equity prices will indeed have been high, and returns will indeed be low. If the economy holds out until 2020 or longer, though, then today’s values should look reasonable.”

Unfortunately, while stock markets tend to tumble when the economy goes South, since the Great Depression there’s scant evidence that single recessions tell us anything about how stocks are priced or indicate anything about their future 10-year returns. For that all-important forecast, one must consult starting valuations more than recessions or moment in the economic cycle.

Consider the 50% decline the S&P 500 Index suffered from 2000 through most of 2002. The recession in 2000 was minor. In fact, it didn’t’ even meet the standard definition of two straight quarters of GDP contraction. GDP contracted in the second quarter of 2000, then again in the fourth quarter of that year, and never again.

Did that recession warrant a 50% price reduction in stocks? Did it somehow prove that stocks were overpriced? Or were stocks just wildly overpriced to begin with, as the Shiller PE hit 44 in early 2000?

The point isn’t that we may or may not have a recession over the next 2, 3 or 5 years. The point is stocks are at a Shiller PE seen only twice before in history – 1929 and the run-up to 2000. Come recession or not, over the next decade investors in the S&P 500 will capture a 2% dividend yield. They may also capture 4%-5% earnings-per-share growth. That puts nominal returns at 6%-7%, which isn’t bad at all. Unfortunately, the third component of future returns consists of where the future PE ratio will sit. Will the Shiller PE maintain itself above 30? Or will it contract to something resembling the historical average of nearly 17? Even if that average is outdated, is the new norm 32? Or is it more like 20 or 22?

Whether a recession comes within the next 5 years or not has little to do with these questions. And though it may send stocks down for most of its duration, it ultimately will have told us nothing about longer term returns compared to how much starting valuation can tell us. In fact, the two features of the Shiller PE are that it’s based on a prior decade’s worth of earnings and is pretty good at forecasting the next decade’s worth of returns. It’s not based on short-term earnings, and it’s not good at forecasting short-term stock returns. A recession doesn’t matter one whit insofar as it’s a typical part of a full cycle that the Shiller PE aims to capture in its earnings calculation and in its stock return forecast.

It’s possible we might wake up in a decade to a 32 Shiller PE. And it may have remained there all along, or it may have arrived there again as the result of any number of gyrations. The question is what should financial writers be telling their readers (and financial advisers telling their clients) about that possibility?