This has been a chaotic year in the financial world. In this latest article, I will take a look at what happened in 2011 and give my personal views on where things are going for 2012.
Many Happy Returns?
The biggest news of the year would have to be Europe. As I write this, the EAFE index of international developed-market stocks has returned -12% for the trailing 1-year period and an annualized -4.7% per year over the last five years. The EAFE index has a 15-year annualized return of 3.3% per year.
The S&P 500 Index has delivered 2.8% for the trailing 1-year and stands at almost exactly 0% total annualized returns (including dividends) for the trailing three years. On the other hand, the trailing 15-year total return for the S&P500 is 5.4%, comfortably above inflation, which has averaged about 2.4% per year over this same time period. A real return (return minus inflation) of 3% per year is not great, but it’s not terrible.
Bonds have been very good to investors in recent years. The BarCap Aggregate Bond Index (a common benchmark of bond performance) is up by 7.7% for the trailing 1-year period and 6.3% per year over the past fifteen years. The major concern with bonds overall, however, is that the big gains in price have resulted in very low yield. The current yield on AGG, an ETF that tracks the BarCap Aggregate Bond Index is around 2%. I say around 2%, because there are multiple ways to measure yield. The SEC yield, a measure developed by the SEC, for AGG is 2.08%. The yield-to-maturity (YTM), which measures the yield an investor would receive if he bought all of the bonds in the ETF today and held them to maturity, is 1.84%.
There is a standard argument that investors need exposure to stocks in order to ensure that their portfolios grow faster than inflation. Over the last fifteen years, domestic stocks (e.g. the S&P 500) have provided investors with a real 3% growth rate. International stocks have provided 0.9% per year in real return over the same period. Bonds have provided investors with a real return greater than either foreign or domestic stocks, but the current yields are below the current level of inflation. Treasury bond yields cannot sustainably stay below the rate of inflation. For this reason, financial gurus such as Burton Malkiel feel that Treasury bonds will be likely to under-perform relative to inflation in coming years.
Where Returns Come From
Investors hope to realize returns on their investments from several sources. Bonds are a form of debt, issued by either government entities or corporations. Investors in bonds can expect to receive interest on the money that they lend and a return of principal. Bonds are not risk-free, of course. In the case of corporate bonds, the company may go bankrupt and not be able to repay its debts and bondholders may lose some or even all of their principle. The other major source of risk with bonds is interest rates. If interest rates rise, even the full repayment of principal and interest may leave an investor with less wealth in terms of purchasing power than she invested. With 10-year U.S. Treasury bonds yielding around 2% and inflation at around 2.4%, this is a meaningful risk.
In the same way that investors are hurt by a rise in interest rates, investors gain from a fall in rates. The falling interest rates of recent years, combined with the Fed’s commitment to keeping interest rates very low, have driven up bond prices and thereby contributed to the high total returns from bonds in recent years.
Returns from equities are quite different. When you buy shares in a company in the form of stock, there are two sources of income: capital appreciation and dividends. Dividends are the share of a company’s earnings that are paid back to shareholders, generally on a regular schedule. Capital appreciation is the profit from selling shares for more than you buy them for. Prices of shares go up if the market’s perception is that the company is going to be worth more in the future. Changes in the market’s consensus opinion of the value of a stock are often very volatile. A better-than-expected earnings report often results in an increase in the price of the stock. The company has been doing better than the market expected, so there is some rationale for a price increase. Price appreciation can also be driven simply by a mismatch in supply and demand for shares. When the market rose by double digits every year in the mid to late 90’s, individual investors poured into the market and the demand for shares skyrocketed. Prices rose to reflect higher aggregate demand for shares. During such times, you will see broad increases in the prices of shares as compared to fundamental measures of value such as earnings, sales, or book value.
Dividends are relatively stable, but price levels are not. What can we expect in terms of price appreciation in the coming years? There are a number of factors that will determine how quickly earnings grow and whether or not investors will have an increased appetite for risky assets such as stocks.
Measures such as Graham-Shiller’s PE10 Ratio do not make stocks look cheap. The dividend yield of the S&P 500 is low, which also suggests that stocks are not low-priced. Certainly if we have a high level of economic growth, this will bode well for stocks. There are some structural issues that will act as headwinds to price appreciation in stocks. One of the largest of these is our stubbornly high unemployment levels. A large fraction of our economy is driven by individual consumers and people who are unemployed, under-employed, or simply worried and insecure do not have money to spend.
While there is plenty of bad news, however, there is also considerable potential for investors. The best returns are often available to those investors who are willing to be unorthodox. For example, in the last couple of years, many investors have totally avoided high-yield bonds (a.k.a. junk bonds). This asset class has turned in a solid performance in recent years, precisely because investors have been so fearful. The same is true of municipal bonds. In the case of both munis and high-yield bonds, there are legitimate risk concerns but the market has priced-in failures on a catastrophic scale. Even so, in general, it is a good idea to treat any ‘common wisdom’ on the future performance of an asset class as highly suspect.
Utility stocks have turned in an outstanding performance in recent years, despite the fact that they have historically been regarded as stodgy or boring investments. When I was writing about utility stocks in late 2006, my analysis suggested that this largely-unloved asset class was likely to outperform the broader market. Over the five years since I wrote that analysis, utilities have outperformed the S&P 500 by about 3% per year. Now, I am not suggesting that I have great powers of prediction—and neither am I suggesting that utilities are especially attractive now. What I am suggesting is that despite the high valuations and low dividend yields of broad stock market indexes along with the low yields of bond indexes, there are parts of the market that look attractive and that are likely to provide investors with solid returns for the risk that they must bear.
The Punch Line for 2011?
So, what is the punch line as we close out 2011? For the most part, 2011 has been an example that markets are fairly sensible. We hoped for a real economic recovery, but there was no real evidence that a recovery was building and the stock market has generally reflected this. No new crisis, but also no strong recovery. There was bad news in Europe and investors reacted as we might expect. Money fled Europe for what were perceived as safer markets. Moving forward, experts and individual investors alike are trying to figure out some firm ground for creating an expectation of future returns for stocks, bonds, and a range of other asset classes. This is a hard problem, but this is always a hard problem.
I cannot really predict which asset class will do well and which will crash in 2012. Personally, my plan for 2012 is the same plan I use every year: I focus on how much risk to take on and how to build the most diversified portfolio that I can for that associated risk level. (In fact, the last several years have further convinced me of the wisdom of this approach.) Along with diversifying, I then choose how much of the return from my portfolio I want in the form of income (dividends, bond yield, etc.) and how much I want to target towards price appreciation. Beyond these three factors, there are certainly arguments in favor of a tactical overlay and I have nothing against tactical asset allocation.
Largest Lesson Learned in 2011: Humility
Perhaps the largest lesson that has really hit home for me in 2011 is the impact of estimation risk. To be investors, we must come up with estimates of risk and return. For many, this will be as simple as believing that stocks will return an average of 10% per year over the ‘long run.’ Others will comb reams of research on the economic fundamentals trying to estimate risk and to determine which asset classes will out-perform.
Recent research, which I discuss in the link above, really makes the point that our ability to form estimates of even long-term future returns is very limited. Even the most skilled of analysts and portfolio managers get caught putting too much faith in their projections. Perhaps the most widely-noted of these ‘estimation errors’ this year was Bill Gross’ call that Treasuries would under-perform. The world is changing and while we must act of our estimates and forecasts, we will do well to maintain a high degree of humility as far as the accuracy of those projections. For the New Year, make sure that the investments that you hold reflect not only your opinions and outlook, but also that you understand the risks, not least the risk that your forecasts go awry. The solution is to hedge your outlooks using active diversification strategies.