Statistically, the current real earnings yield results in an expected real annual return over the next ten years of 4.1%, well below the historic norm since 1926 of 6.6%. In essence, this 4.1% forecast reflects the stock market gradually reverting to its long-term normative valuation. Should valuation levels remain above the long-term norm or even increase from today's levels, the expected annual real return might reasonably range up to a high of 6.3%. Conversely, a trend to lower valuations might result in real annual returns as low as 2.0%.
Regardless, the message is clear. At today's valuation levels, long-term real returns from U.S. large company stocks are going to be in the low to mid single digit range. And mind you, these returns are before the drag of costs and taxes. For investors in or approaching retirement, such return prospects are daunting.
Investors seeking higher returns will need to go farther afield. Historically, both value and small company stocks have provided return premiums to the market overall. (See our Commentaries - Beating the Market and Good Things Come in Small Packages at http://www.tacitacapital.com/?q=node/29). High dividend yielding stocks have also historically earned a premium to the market. Emerging markets may offer the opportunity for higher returns. Moreover, the potential devaluation of the U.S. dollar to emerging market currencies might even enhance such returns.
High net worth investors may want to look at certain alternative investment strategies including longer-term, illiquid investments. The heightened return potential of such strategies is not a free lunch. It reflects their unique risk characteristics – leverage, credit, tail risk and illiquidity. Yet, carefully selected, such strategies have the potential to both augment returns and diversify portfolios.
Thoughtful investors need to come to grips with the low real return potential of the broad stock market. They then need to robustly diversify in pursuit of potential return premiums.
November 30, 2010
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