Friday’s column suggested retirees own stocks. Over the past 90 years, investors have rarely been punished for holding stocks, assuming they held onto their positions. Not only did 100% equity portfolios reliably allow for higher spending rates in retirement than bond portfolios except during the onset of the Great Depression, but these allowances roughly matched the rates achieved. through balanced portfolios, while offering higher growth potential. Win-win.
Today’s article complicates this wonderfully simple precept. (Investment writers can never do well enough.) The precept “the more stocks the better” assumes that the future will look something like the past. It seems a wise bet, given the amount of investment data. However, the sample size is small, as it contains only three independent 30-year periods spanning a full century. In addition, stocks have become unusually expensive. History can therefore prove to be an unreliable guide.
The chart below shows that US equity valuations are currently occupying strange waters. Obtained from data on the website of Nobel Laureate Robert Shiller, it describes the century-old history of the stock market’s CAPE ratio, which divides the current market capitalization by the average earnings of its constituents over the previous decade. . The higher the number, the more bullish the stock price is.
The current CAPE ratio of 38 was only broken once, in December 1999, when the measure hit 44. (The date should appeal to millennials.) So far, investors who have stayed put have prospered, because although stocks crashed again in 2008, they have since rebounded so massively that their CAPE ratio now exceeds the previous second-place figure, which occurred on the less-than-auspicious date of October 1929.
Consider the alternative
That stocks recovered almost immediately was not inevitable. Stocks may well have rebounded for many years to their post-2008 valuations, which, after all, resembled their previous norm. If that had happened, the argument that retirees prefer stocks would require a few asterisks.
Morningstar researchers anticipate such a result in the market. The wing of the firm that forecasts asset class returns, Morningstar Investment Management, predicts that US stock valuations will drop to something near their long-term average and then stay at that level. Therefore, their estimates for stock returns for the next 30 years are mixed. (Researchers from the world’s largest asset manager, BlackRock, come to a similar conclusion.)
Less controversially, the group also expects a weak bond performance. It will almost certainly happen. Over the past century, long yields on US Treasuries have averaged 5.0%. Today, 30-year Treasuries are paying 1.7%. With yields at this level, there is no realistic profit potential for bonds, unless US inflation completely subsides and becomes outright deflation. Otherwise, the best fixed income securities can do is fend for themselves.
The following table shows the real annualized rates of return (ie the performance after inflation) of US stocks and bonds over four different periods: 1) 1930 to 1959; 2) from 1960 to 1989; 3) from 1990 to 2019; and 4) from 2021 to 2050. The first three series represent actual results, while the fourth series contains estimates from Morningstar Investment Management. The latter, of course, comes with no guarantees. Nonetheless, it provides a useful testing ground for assessing what retirees should do if stocks cease to be consistently generous.
Morningstar Investment Management expects real stock returns for the next 30 years to be much lower than those from 1930 to 1959, which included the Great Depression. At first, this projection seemed indefensible to me pessimistic. But when I reconsidered the question, I realized that stocks had real annualized gains of 5% over several 20-year periods, including 2000 to 2019. So it hardly seems unreasonable to believe that. they could do it for the next 30 years.
The bond forecast is also lagging behind historical results, but this forecast is, to say the least, optimistic. The yield on inflation-protected 30-year Treasury securities is currently negative 0.56%, which means that investors who own these securities have voluntarily agreed to receive half a percentage point less per year than the inflation rate. In this light, expecting even a slight gain in bonds looks promising.
Incorporating the forecast into a withdrawal rate model that calculates safe spending rates for given levels of asset class performance and inflation rates – for details on these calculations see Friday’s column – generated estimates for today’s harvest of retirees. They are shown below, along with comparable figures for prior periods. (The three portfolios consist of: 1) 100% stocks, 2) 50% stocks, 40% bonds and 10% cash, and 3) 90% bonds and 10% cash.)
The painting tells three stories. First, whether aggressive, moderate, or conservative, the projected spending rate for each portfolio follows what history has allowed. Future retirees should therefore lower their expectations in terms of withdrawal rates. Second, despite their unimpressive predictions, bonds will almost hit the expense rate that can be safely mined from a portfolio of just stocks. In the past, stock returns were so high that they fully offset the additional volatility in stocks. Morningstar Investment Management no longer believes this will be the case.
Third, balanced portfolios work well. Their calculated withdrawal rate is 40 basis points per year higher than that of a portfolio consisting only of stocks, which represents an unusually high margin of victory. It was not until 1930 to 1959 that the stock and bond portfolio conferred a greater advantage in terms of spending rates. Not that Morningstar Investment Management, or any other reputable organization, isn’t predicting a repeat of the Great Depression. This is not the claim. Rather, the point is that the best time to diversify is when investments have become expensive, implying that returns may be low.
After taking a little detour to review the details, I can again offer you some simple advice. Retirees who see market lessons as constant should focus on equities. They don’t need to read any further than the Friday column. However, those who believe that the stock market may have finally exhausted its good fortune, so that a slowdown will not be quickly followed by a strong rally, should invest only moderately in stocks. From 30% to 50% seems appropriate.
John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler Report, his opinions are his.