Some Thoughts on Future Returns
It is important to have return expectations that are not strictly based on recent returns, but also consider the current environment and the range of possible returns.
Most investors base their expectations on historical returns but they are simply a starting point. For example, returns on cash or money market investments have averaged about 3.5%, before
inflation and taxes, over the last 90 years. Today investing in a money market fund will produce just a hair more than 0%. This results in an expectations gap of 3.5% per year. Or even more extreme: In December 1999, the S&P 500 index had seen annual gains of 20% over the previous five years. Investors with that expectation for the next five years, would have been very disappointed with the 2.2% actually received – an annual expectations gap of more than 17%.
Fast forward to today. The strong returns we have seen from the U.S. markets over the last five years certainly reflect an economic recovery since the 2008-09 Financial Crisis but may also include some borrowing of future returns. Over the last five years, U.S. large company and small company stocks have produced a nearly identical return of 14.5%. Contrast this with the much lower 6.2% in International stocks, the nearly 2% on Developing Market stocks and the negative 5% return on commodities. We ask ourselves whether the returns on U.S. stocks are likely to persist over the next five years? Our answer is; “Likely not. They are likely to be more modest.” And we ask ourselves whether the returns on International and Developing Market stocks, and commodities are likely to be as low over the next five years? Our answer is; “Likely not. They are likely to be higher than the last five years.”
Of course, we are not able to predict the level of future returns for any investment so please don’t interpret our thoughts on this as advice to sell your U.S. stocks and put everything into Developing Market stocks! What we do know, is that over the last 90 years, there were 332 rolling five year periods out of 1012 where U.S. stocks produced a return of 14.5% per year or better – that’s 33% of the time. The other 67% of the time the returns were less than 14.5% per year over five years. So odds are that over the next five years we will see returns on U.S. stocks that are lower than the last five. And we are certainly not suggesting that the returns over the next five years will be negative for U.S. stocks – historically that’s only happened 13% of the time – a fairly low chance but certainly always possible.
Many U.S. investors see U.S. based companies as less risky than companies domiciled in international and developing markets. While this may be the case for specific countries (e.g. Russia), often companies in these “riskier” countries trade at far lower valuations, thus offering a potential reward for the higher risk. In our view, a well diversified portfolio that includes U.S., International and Developing Markets will help to reduce both the foreign “country risk” and the “valuation risk” that is present in the U.S. market today. There is nothing inherent about investing in the U.S. that always makes it safer for an investor. For the long-term investor valuations always matter.
Important Note: These materials are provided for informational purposes only. Please do not assume that any information contained in this Insight serves as the receipt of, or as a substitute for, personalized investment advice from Madison.