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Why Market Returns May Be Lower in the Future

Key Points
  • Market returns on stocks and bonds over the next decade are expected to fall short of historical averages.

  • The main factors behind the lower expectations for stock market returns are low inflation, low interest rates and less growth in price-to-earnings (P/E) ratios.

  • It is important to maintain long-term financial objectives that are based on reasonable expectations.

Market returns on stocks and bonds over the next decade are expected to fall short of historical averages, according to 2017 estimates by the market analysts at Charles Schwab Investment Advisory, Inc., a separately registered investment advisor and an affiliate of Charles Schwab & Co. Inc.

This article provides a broad overview of the methodology used for calculating our market return estimates and highlights the importance of maintaining long-term financial objectives that are based on reasonable expectations.

The main factors behind the lower expectations for market returns are below-average inflation (despite a recent rise in expected inflation); historically low interest rates; and less growth in price-to-earnings (P/E) ratios due to lower expectations for long-term economic growth. These are anticipated to act as long-term drags on returns and yields.

The reduced outlook follows an extended period of double-digit returns for some asset classes, as shown in the chart below. As such, now may be a good time for investors to review, and consider resetting, long-term financial goals to ensure that they are based on projections grounded in disciplined methodology and not historical averages.

Our estimates show that, over the next 10 years, stocks and bonds will likely fall short of their annualized returns from 1970 to 2016. The estimated annual expected return for U.S. large-cap stocks from 2017 to 2026 is 6.7%, for example, compared with an annualized return of 10.3% during the historical period. Small-cap stocks, international large-cap stocks, core bonds and cash investments also are projected to post lower returns through 2026.

Here are answers to frequently asked questions about these market estimates:

Why are long-term estimates of returns important?

How do you calculate your long-term forecasts?

Why do you expect long-term returns to be lower than historical averages?

What could lead to higher returns?

What can investors do now?

Why are long-term estimates of returns important?

A sound financial plan serves as a road map to help investors reach long-term financial goals. To get there, investors need reasonable expectations for long-term market returns.

Return expectations that are too optimistic, for example, could lead to a delayed retirement or make it difficult to pay for a big expense such as a college education.  If return expectations are overly pessimistic, too much may be saved in the nest egg at the expense of everyday living.

How do you calculate your long-term forecasts?

The long-term estimates cover a 10-year time horizon. We take a forward-looking approach to forecasting returns, rather than basing our estimates on historical averages.

For U.S. and international large-capitalization stocks, we use analyst earnings estimates and macroeconomic forecast data to estimate two key cash-flow drivers of investment returns: 1.) Recurring investment income (earnings); and 2.) capital gains generated by selling the investment at the end of the forecast horizon (10 years). To arrive at a return estimate, we answer the question: What returns would investors make if they bought these assets at the current price level to obtain these forecasted future cash flows?

For U.S. small-capitalization stocks, we forecast the returns by analyzing and including the so-called “size risk premium.” This is the amount of money that investors typically expect to earn over and above the returns on U.S. large-capitalization stocks.

For the U.S. investment grade bonds asset class, which includes Treasuries, investment-grade corporate bonds and securitized bonds, our forecast takes into account both the yield-to-maturity (YTM) of the 10-year U.S. Treasury note, a risk-free rate, and a corporate credit risk premium.* We believe the future level of returns an investor will receive, even if interest rates rise, is reflected with YTM. YTM is the return an investor can expect to receive if the bond is held until its maturity date. Although cash yields are currently negligible, we believe cash will keep up with the rate of inflation over the long run.

Why do you expect long-term returns to be lower than historical averages?

Three primary factors are behind the forecast for reduced returns: lower inflation, low interest rates and less expansion of price-to-earnings (P/E) ratios.

  • Low inflation. Inflation averaged 4% annually from 1970-2016. Our forecast is for inflation to average 1.9% from 2017-2026. This is a slight increase from last year. It is still, however, less than half of the historical average. When the rate of inflation is low, bond yields also are low. That is because bond investors generally do not require as much yield premium to compensate for the erosion in buying power that inflation can inflict on a portfolio. For stocks, low inflation historically has meant low nominal (before inflation) returns.
  • Low rates.  Lower inflation generally means low nominal (before inflation) interest rates. This affects yields on everything from cash to 30-year Treasury bonds. By historical standards, we are also in an era of low real rates (i.e., rates after adjusting for inflation) and this is likely to continue because the consensus forecast for global economic growth is much lower. Low yields mean investors earn less from the fixed-income portion of their portfolios. Stock returns tend to be higher than bond yields due to the relatively greater risk in holding stocks. When bond yields are lower, stock returns tend to be lower.
  • Price-to-earnings ratios may not expand as much. Price-to-earnings (P/E) ratios, which tend to indicate how much investors are willing to pay for each dollar of corporate earnings, grew between 1970 and 2016. The expansion of P/E ratios could be due to various reasons, including investor optimism about higher future earnings, less aversion to risk and lower interest rates. The rise in P/E ratios boosted average returns for stocks, but it is unrealistic to expect similar P/E growth over the next 10 years.
Curb Your Expectations chart

What could lead to higher returns?

Returns could exceed our expectations if the U.S. economy grows faster than we anticipated. This would likely lead to higher earnings growth, likely driving stock returns and core bond yields higher. The years 1990-1999 were an example of an expansionary period when the U.S. economy grew 3.2% annually on average. Corresponding returns from U.S. large-capitalization stocks were 18.2% on average and core bonds yields averaged 7% despite severe market turbulence in 1998.

Historically, some of the best periods for investors to receive higher returns have been when they simply stayed in the market or even invested more money during market downturns. In valuation terms, a lower price-to-earnings (P/E) ratio when it is due to a disproportionately lower “P” than warranted by “E”, generally has led to notably positive outcomes for investors. In recent times we have seen examples of this, especially soon after the 2008-2009 financial crisis. During this period, the stock market sell-off was disproportionately larger than the earnings downturn, creating attractive valuations, and in our view making it an opportune time to invest in stocks because of the subsequent sharp rebound.

What can investors do now?

Thanks to the power of compound returns, what investors do (or don't do) today can have big implications on their ability to meet their long-term goals.

Here are a few things to consider doing. First, if you don't have a long-term financial plan, now is a good time to put one together. Second, try to minimize fees and taxes, particularly in a lower-return environment. And last but not least: Build a well-diversified portfolio.

I hope this enhanced your understanding of how we calculate market return estimates and why these are important for investors to consider when setting their long-term financial objectives.

Next Steps

To discuss how this article might affect your investment decisions:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.

 

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Important Disclosures

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