According to Jack Bogle and Michael Nolan, U.S. stocks are projected to gain about 6% per year over the next decade. Bonds are projected to earn about 3%. These return projections are significantly lower than the long term averages of 9% and 4.5%, respectively.
For the bond market, future returns are expressed as the current yield to maturity. The yield to maturity on 10-year Treasuries is 2.4%, which Bogle and Nolan round up to 3%. (This could be justified by the addition of higher-yielding bonds.) Since today’s 10-year Treasury yield is 2.3%, that estimate looks reasonable.
Stock market returns have three components:
- the market’s current dividend yield
- the estimated annualized growth in corporate earnings
- the expected change in the market’s price/earnings ratio
Stock Returns = dividend yield + earnings growth +/- (change in P/E ratio)
With the stock market today yielding about 2% and historical earnings growth of 4.7%, Bogle/Nolan arrive at a preliminary estimate of about 7% per year, which they reduce to 6% by figuring that today’s P/E ratio will end up ten years from now at its long term average of 17.8.
Enterprise Returns and Speculative Returns
Bogle took inspiration from John Maynard Keynes. Keynes believed that the best economic models are as simple as possible, with components and results that are clearly understood. For example, stock returns could be decomposed into two sources: enterprise returns, which are the returns that came from the growth (or shrinkage) of the intrinsic business, and speculative returns, which come from changes in investor psychology. Bogle uses Keynes’ framework to construct his model. Dividend yield plus earnings growth measures the stock market’s enterprise returns. The last Bogle term – the change in the P/E ratio – equates to Keynes’ concept of speculation.
What’s An Investor To Do?
First, expect lower than usual returns from both stocks and bonds.
There’s no way for bonds to achieve high returns, given a starting yield of 2.4%. As usual, stocks offer less certainty. It’s possible that continued low inflation justifies a market P/E ratio of 25 or higher, leading to annualized stock-market gains that approach 10%. But it is also very easy to envision scenarios that fall short of Bogle’s estimate. The 6% estimate is not overly cautious.
Second, inflation-adjusted returns look a little less onerous.
Bogle’s models don’t take into account the effects of inflation, but today’s bond yields implicitly forecast low future inflation. If that proves true, bonds could eke out a modest real gain. Stocks would of course fare even better. A 6% nominal gain with 2% inflation means a 4% real return, which is respectable if not spectacular by historic standards and flat-out terrific compared with the paltry yields now paid by Treasury Inflation-Protected Securities.
Third, the relationship between stocks & bonds looks normal.
The historic return premium offered by stocks over bonds has been 4.6%. That would suggest a modest relative advantage for bonds. On the other hand, because bond yields are so depressed today, the ratio of stock-to-bond returns is not particularly low. Bogle and Nolan find no relationship between forecast equity premiums and future stock returns.
Investors have to make some important decisions. If they keep their asset allocations as they are, they will probably end up with smaller account balances than they had hoped for in ten years. Bogle and Nolan do not interpret their findings as suggesting that investors should change their asset allocations.
If lower account values are not acceptable, investors can either take more risk, or increase their savings rate to make up the expected shortfall. Neither of these is an ideal solution. Taking more risk will not guarantee a better outcome in ten years. And many investors simply can’t increase their savings rate due to already-stretched finances.
But it’s important to face up to the fact that the expected returns over the next ten years are going to be lower than usual. Ignoring this warning and hoping for the best is an option, but not a very practical one.