Michael Dever & Ryan Bonaduce
Brandywine Asset Management
December 10, 2021
Introduction / Abstract
One traditional investment approach, referred to as a “balanced” portfolio or “60/40” portfolio, centers around allocating 60% of a portfolio to stocks and 40% to bonds. This portfolio composition is intended to provide much of the upside opportunity of owning stocks but with reduced downside risk due to the non-correlated returns being earned from the bond position. In line with this expectation, a 60/40 portfolio has historically resulted in returns that trail those of owning a 100% equity portfolio, but risk, including event risk as evidenced by maximum drawdown, has also been reduced.
While many investors considered the historical returns and risk associated with a 60/40 portfolio to be an attractive alternative to a 100% equity portfolio, reduced bond yields and an elevated price-to-earnings (“P/E”) ratio are likely to limit the potential benefits of the 60/40 portfolio in the 2020s. This is due to two primary drivers:
- Over the past decade, the U.S. equity markets have performed better than average, leading to valuations that today exceed historical averages. For example, profit margins and the cyclically adjusted price earnings ratio (“CAPE”) popularized by Nobel Laureate Robert Shiller, are both at historically elevated levels. While some of this P/E expansion can be attributed to the low level of interest rates relative to long-term averages, that driver is unlikely to provide further P/E expansion going forward.
- The annual earnings growth from 2010-2019 is 9.89% which is considerably higher than the historic average annual earnings growth rate of 4.46% dating back to 1900. Many of the drivers that contributed to earnings growth over the past decade, such as quantitative easing and fiscal largesse, are unlikely to continue during the 2020s.
In his 2011 book, Jackass Investing, Don’t do it. Profit from it., one of us (Michael Dever) discussed three Return Drivers that power stock market returns. They are:
- Corporate earnings growth
- Investor sentiment
In the following paragraphs, we will explain how each of these three Return Drivers will contribute to equity market performance through 2029.
Return Contribution from Corporate Earnings Growth
The historic annual earnings growth rate since 1900 for companies in the S&P 500 is 4.46%. The most recent decade saw this increase to 9.89%. We anticipate that long-term averages will be reasserted, as the confluence of relaxed monetary policy and deficit-fueled fiscal spending that help support the higher growth rate are unlikely to continue indefinitely.
While some of the earnings growth was fueled by top-line revenue growth, a sizable portion of the growth can be attributed to an increase in profit margins. Historically, profit margins have oscillated around 7%. In contrast, the average profit margin from 2011-2020, was 10.4%[i]. We do not think “this time is different” and that the elevated profit margins are here to stay. Corporate competition will eventually win out and cause a reduction towards the longer-term average throughout the 2020s.
As a result, we project the profit margin through 2029 to be around 8.22%. Even this would be higher than the historical average. But as this is a reduction from current levels it will have a negative effect on earnings growth relative to the past decade. This leads to projected earnings growth of 4.31% annually through the 2020s.
Return Contribution from Investor Sentiment
In his book, Dever explains that investor sentiment is the number one Return Driver for stocks for a period of less than 20 years. The best way to get a glimpse at overall sentiment is the P/E ratio. Of the many ways to calculate P/E, the one we prefer is the aforementioned CAPE.
The CAPE ratio is different than the P/E ratio in that it smooths earnings over a ten-year period to reduce the impact of outlier events such as the COVID crash or the 2009 financial crisis.
Robert Shiller brought CAPE to the public in his book Irrational Exuberance, in which he compares the S&P’s current price to the 10-year average of earnings. Since 1900, CAPE has averaged 17.04. At the end of the year in 2020 however, CAPE was 33.77, and as of this writing in December 2021, CAPE is in excess of 38, more than twice its long-term average.
Accounting for the possibility that this decade could support an elevated CAPE (relative to the last century) we have adjusted our projections to allow for a slightly inflated CAPE. Rather than using the historical average of 17.04, we have used a more conservative reduction to 20.53, which is the average from 1970-2020. Even with this more generous number for CAPE, the result is a negative contribution of -5.38% to the annualized equity market growth rate. (It is worth noting that if CAPE does fall to its long-term average of 17.04, that projects an annualized contribution to equity returns of -7.32% annually.)
Return Contribution from Dividends
At the end of 2020, the dividend yield on the S&P 500 was 1.58%. This equates to a dividend payout ratio of 62%, which is only slightly higher than the 121-year average (since 1900) of 58%. Assuming the payout ratio stays close to its current level, we expect the dividend yield to increase throughout the decade due to earnings growth. Our projection is for an average contribution of 2.90% from 2020 to the end of 2029.
Calculating the S&P 500 Total Return
After calculating projected performances for each of the three Return Drivers, we can determine the average annual return for the S&P 500 total return index from year-end 2020 to year-end 2029. The following is the contribution of each Return Driver, totaled together to get the full return.
Earnings Growth: +4.31%
Investor Sentiment: – 5.38%
The end result is a projected annualized return from the S&P 500 of 1.83% throughout the 2020s. This is less than the projected inflation rate of just under 3% annually. But much of this lower return (relative to the return during the 2010s) is due to an assumption that investor enthusiasm towards stocks will revert to its mean from 1970 – 2020. It is possible that “this time is different” and that investors remain enthusiastic towards stocks throughout the 2020s, resulting in investor sentiment being a neutral or even more positive contributor towards performance.
Return Contribution from Bonds
The final component for calculating a future return from a 60/40 portfolio is an estimate of the return to be earned from the bond portion of the portfolio.
Since 2004, the Barclay Aggregate Bond Index averaged annual returns of 4.25%[ii]. However, this is not representative of the expected future returns, as the two dominant Return Drivers are now projecting substantially lower returns. These are:
- The capital appreciation provided from interest rates falling from 6.5% in January 2000 to 0.36%[iii] in December 2020. This is
unlikely to be repeated, and
- The average yield of 4.4% from January 1985-July 2021 on the 5-year treasury note, which approximates the yield on the Index, is now at 1.90%[iv].
With the Barclay Aggregate Bond Index now yielding 1.90%, the bond returns over the rest of the decade are likely to be similar to this current yield of the Barclay Aggregate Bond Index.
Calculating The Return on the 60/40 Portfolio
Following all the previous calculations, from year-end 2020 through year-end 2029 we should expect the return from a “balanced” 60/40 portfolio to look like this:
Stocks (60%): +1.83%
Bonds (40%): +1.90%
Total (60/40): +1.86%
= [Projected Annualized Return of 60/40 Portfolio]
This return could prove problematic for many people and pension funds. Many individuals today expect to earn portfolio returns of 10% or more (a recent article showed larger individual investors expect to earn 17.5% in their portfolios over the long term[v])! These people are almost certain to be disappointed. State and local pension funds, on average, are targeting a 7% annualized return on their investments. Returns of less than 2% annually will further exacerbate their underfunded positions.
Furthermore, according to Shiller, markets with CAPE levels that we see today provide for even higher volatility than normal. Overall, the projections are showing below average returns with above average volatility. This is just a warning that every investor needs to temper their expectations.
These projections should not be seen as outliers, just as the losses suffered in equities in 2001, 2008, and during the COVID crash should not be glossed over as outlier events. A true outlier event would be a decade without crashes or with continued double digit returns from a 60/40 portfolio.
Increasing Returns and Reducing Risk with Return Driver Based Investing
Fortunately, there is an alternative to the classic 60/40 portfolio. “True” portfolio diversification is the one true “free lunch” of investing, where you can achieve both greater returns and less risk. But true portfolio diversification can only be obtained by diversifying your portfolio across multiple Return Drivers[vi], not asset classes. Dever gives examples of a truly diversified portfolio in the final chapter[vii] of his book, and we are pleased to provide a complimentary link to that chapter here: Myth 20. While some people may prefer to gamble on a less-diversified 60/40 portfolio, as the book shows, in the longer-term true portfolio diversification can lead to both increased returns and reduced risk. And especially today, the odds do not favor gambling on 60/40.