Despite last week’s pullback, the Dow industrials are within 3 percent of their all-time high.
Does that mean an “all-clear” sign for investors, a signal that the 20 percent market returns of the 1990s are back again, ready to fix beleaguered 401(k) accounts and pension funds alike?
Professionals think not. And that’s not simply because of immediate threats such as oil prices.
Since the Dow Jones industrial average peaked at 11,722 in January 2000, market analysts have become a more sober crew. Instead of the creative accounting and the dreamy thinking that supercharged the market and gave investors annual returns over 20 percent for five years in a row at the end of the ’90s, analysts have gone back to calculating returns based on old principles of investing.
Now, focused on key factors that determine returns–such as the dividends companies pay, bond yields and the rate of earnings growth–they see little reason why the market should bestow more than 7 or 8 percent annually during the rest of this decade. For some, the expectations are even more sobering.
Robert Arnott, chairman of Research Affiliates in Pasadena, Calif., and editor of the Financial Analysts Journal, began a presentation to analysts at the CFA Society of Chicago recently with this warning: “My doom-and-gloom remarks should be short, but not sweet.”
Arnott theorizes that after the manic period of the last decade returns aren’t likely to exceed 3 percent above inflation on average per year for the next decade, because the market historically languishes for more than 15 years after periods of exuberance.
That should give pause to individual investors, many of whom have been counting on the market’s historical average of about 10 percent annual returns in their financial planning. The difference between 6 percent and 10 percent average annual returns can amount to hundreds of thousands of dollars to an individual’s retirement portfolio.
Arnott points out that if the effects of investor excitement were removed from the last decade investors would have earned much less than they assumed was the norm. Focusing on typical drivers of returns, he said a classic portfolio of 60 percent stocks and 40 percent bonds would have provided a return of only 5 percent annually.
And, he said, “3.3 percent of the annual return for a 60/40 asset mix over the past decade came from rising [price-earnings ratios], falling dividend yields and falling bond yields, which we dare not rely on for setting our return expectation or our spending plans.”
With returns barely making up for the cost of inflation during the next few years, Arnott said, Americans will end up retiring later and poorer.
It’s a view shared by Anne Casscells, a managing director of Aetos Capital in Menlo Park, Calif., who says in a coming issue of CFA Magazine that because “returns aren’t very appetizing,” the retirement age will be moving to 72–perhaps not reaching that point until 2030 or 2050.
She doesn’t think investors should expect returns greater than 4 percent plus the rate of inflation–or roughly 6.5 percent.
“Now earnings are above trend, so the critical question would be: Can earnings continue to grow more rapidly than they have historically?” she said. “That’s really hard to do. Most people don’t realize it, but over the long run corporate earnings don’t even grow as fast” as gross domestic product.
The concerns have been a constant theme among analysts, and a bitter pill for pension funds, which have been assuming returns averaging 8.5 percent annually.
As a result money managers have been looking for ways to add a little something to jolt returns in portfolios above those offered by the stock market and bonds. Within investment circles there has been a quest for what’s called “alpha”–or the little performance beyond that automatically provided by the stock market.
Approaches are many–everything from investing in hedge funds and private equity to emerging markets.
But the trick is to do it without adding too much risk. Often hedge funds employ leverage and take on other risks, and the best aren’t available to investors without multimillion-dollar portfolios.
Steven Ames, an Annapolis, Md., financial planner, has been giving a boost to his clients’ retirement funds during the last few years by investing in commodity, energy and emerging-market funds.
About 20 percent of some portfolios have been in the three highflying areas.
“But its scary,” he said, and he’s been cutting back.
During the last 12 months natural resources funds are up 54 percent, and emerging markets 57 percent, according to Lipper Inc.
Such tremendous returns–like the technology bubble–often are early warning signs of a serious downturn, and emerging-market analysts have been warning investors to be wary.
As a protective mechanism in his own portfolio Ames has kept the highfliers but also holds 25 percent in cash to counterbalance a sharp hit.
Meanwhile, Harold Evensky, a Coral Gables, Fla., financial planner, also has been investing in energy, precious metals and Latin American funds, “but as a risk manager I’m not as comfortable with it as I have been.”
Instead, he says, the one sure thing investors can do in a low-return world is to simply reduce their cost of investing.
“If you are earning 15 percent, and paying 1 percent in expenses, that’s not so bad,” he said. “But if you are earning 8 percent and inflation is at 3 percent, you only have 5 percent. Then paying 1 percent in expenses is 20 percent of your return.”
Consequently, during the last few years he has had his investors invest in fewer funds and puts about half of a portfolio into a Russell 3000 index exchange-traded fund–a low-cost investment in the broad stock market.
“If you can save 0.50 percent in expenses, that’s a lot,” he said.
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Gail MarksJarvis is a Your Money columnist.
