In the first episode of the new HBO series "Luck," a group of four dissolute gamblers use the back of an envelope to draw the possible outcomes of a series of horse races, taking into consideration the horses' recent racing histories, the trainers, the jockeys and so on. If their assumptions are accurate and if nothing unforeseen happens, their winnings will be in the millions.
It struck me, watching the show, that each year feels a bit like this pilot episode, with economists and experts predicting the winners and losers in the economy and capital markets for the coming 12 months based on current market valuations, recent economic news and other signs.
Using sophisticated analysis, very smart people have told us that global growth is expected to be 3.5% in 2012, or 3.2%, or 1.6%. And the S&P 500 will climb 15%, or lose 20%.
Someone just may be right this year. Perhaps.
Here at Vanguard, we look askance at short-term forecasts and try to treat the future with the deference it deserves, using a probabilistic framework for our analysis. Predicting short-term movements is difficult at best, and acting on them can be foolhardy at worst. Just as the race-track gamblers cannot foresee a horse breaking a leg, market participants cannot accurately predict a tsunami, Arab Spring or debt crisis.
Upon examination of the long-term return distributions, we expect that the economy and global equity markets have a decent chance of being in line with historical norms over the next 10 years, giving renewed credence to the traditional principles of portfolio construction and reinforcing the expected risk-return trade-off among stocks and bonds.
EVERYTHING OLD IS NEW AGAIN
For all the talk of a "new normal," a common behavioral bias is that investors tend to focus on recent history, forgetting that markets have always been volatile. The Asian contagion of 1997-1998, the tech bubble, and market decline in 1987 all seem like ancient history. However, this volatility is precisely the reason that over long periods of time the risk premium for investing in equities prevails-because we are being compensated for that risk. Keeping this in mind, we expect that the long-run outlook for the global stock market is likely to be attractive despite a backdrop of elevated market volatility, below-average growth expectations, and near 0% short-term interest rates.
In the newly released Vanguard Economic and Investment Outlook, we suggest a roughly 35% probability of U.S. stocks achieving an average annual return of between 6% and 12% over the next 10 years in line with historical averages.
However, quite a wide dispersion of returns is possible, including a 10% to 15% chance that there could be another "lost decade" of negative average U.S. stock returns. Or on the flip side, a 40% chance for positive, double-digit returns. (As an aside, for an investor who continued to commit assets to a portfolio of 60% stocks and 40% bonds, the decade was hardly lost.)
Our outlook doesn't sound terribly certain, does it?
But that's exactly the point. Under our framework, the fat tails in the distribution of returns may be caused by a variety of potential catalysts. On the downside, a lost decade in stocks could be driven by an unforeseen fiscal crisis in the U.S., a marked drop in U.S. productivity growth, or a sharp and persistent rise in inflation expectations.
On the upside, the markets may be propelled by multiple P/E expansion, higher-than-expected global economic growth, continued advancements in technology (and thus, productivity), and less pessimistic sentiment among global equity investors.
Although the 10-year forecast figures seem widely dispersed, they can't hold a candle to the one-year distributions that are much more volatile and drive home the point that short-term predictions should be viewed with a healthy dose of skepticism.
If forecasting the future were that easy, then actively managed portfolios would consistently and handily outperform a passive indexed strategy every year. Of course, historical performance statistics tell a different story.
The projected distribution for international equities is similar to that of U.S. stocks, with a wide variety of potential outcomes, including a slightly higher probability of negative returns because of the addition of currency volatility in the equation. Market valuations in the U.S. and most regions of the world are quite similar, with negligible differences even between the P/E ratios of the MSCI Emerging Markets Index and those of the broad developed markets at the end of 2011. We believe it is the price paid for growth-not expected growth per se-that ultimately determines returns.
Yet, despite the higher correlations observed between U.S. and international equity markets since the global financial crisis, we believe the case for international diversification remains strong. Correlation is only one measure of diversification. Two countries that have positive returns of 1% and 10% would exhibit high correlation, both moving higher.
But without diversification, the risk is having exposure only to the underperforming country. There will always be localized events and currency movements that keep U.S. and non-U.S. market correlations from being a perfect 1.0, and therefore there will always be some diversification benefit to having a broadly diversified global portfolio.
It should come as no surprise, therefore, that we feel much the same way about the role of bonds in a portfolio. Much has been written about an impending bond bubble, and while we believe that the return outlook for broad bond portfolios is fairly muted over the next decade given the generally low level of interest rates, there is still a distinct place for bonds in a portfolio as a way to mitigate volatility.
The diversification benefits of bonds are expected to persist despite the tendency for slightly higher interest rates over the next decade. There is a downside risk to bonds, but it is much less pronounced than the downside risk to equities over then next decade, and the role of bonds as a cushion for stock-market declines will continue.
Taken altogether, diversified, balanced-portfolio returns over the next decade have a higher chance of matching their long-run averages than some may think, especially when those returns are adjusted for our outlook of future inflation. In short, the distribution of real returns on a balanced portfolio looks more normal than abnormal. Higher risk will accompany higher expected returns and will experience a wider range of expected returns.
We are concerned that the volatile environment has led some investors to retreat from their strategic allocations, while the low-yield environment is leading others to aggressively pursue higher portfolio returns (potentially underestimating the associated risks), higher economic growth (without considering market valuations), or alternative investments (without regard to cost or risk exposure).
We would maintain that the principles of portfolio construction remain unchanged, and that strategic asset allocation and a buy-and-hold approach is still the best way to secure long-term wealth.
Joseph Davis, PhD, is a principal and chief economist at Vanguard.
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