Content provided by Rusty Vanneman, CLS Chief Investment Officer

Having been on the road for most of this past month (hey, it wasn’t all work and no play, I did have an awesome family vacation in there), and in preparation for a lot of travel coming in the next six weeks, I’ve been contemplating what I’ve been hearing from investors. My conversations with investors suggest that many are too positive on expected stock market returns, and too negative on bond market returns. But, what should those expectations be, and what should investors do?

First, when it comes to building return expectations, it’s important to remember that confidence increases as the time frame for forecasted returns extends. This allows more time for valuations to play out. In other words, it’s harder to forecast short-term returns than it is for long-term returns.

There are three basic building blocks for forecasting capital market returns:

• Current yield
• Growth in yield
• Changes in valuations

Let’s first look at bonds. The current yield on 10-year Treasury bonds is just under 3%. There is no growth in that yield. And, if you hold the bond to maturity, there is no change in the asset’s valuation. Thus, if you buy that bond, and hold it to maturity, you will get nearly 3% per year. Future returns for bonds are highly correlated with current yields. (Note: if you buy non-government bonds, you will get additional yield to compensate for credit risk, but you will have to adjust that return expectation lower as you also need to estimate bond default rates and recovery rates for those bonds that do default). A 3% bond market return isn’t that attractive, particularly compared to long-term average bond returns, but it’s still positive (and significantly higher than cash) and not a reason to abandon the asset class.

Let’s move to stocks. The current dividend yield is 2%. To estimate the growth of dividends, many investors like to plug in long-term earnings growth, which is a fairly steady 6% over the decades. That consists of real earnings growth and inflation. Currently, it would be reasonable to expect a haircut to both expected real earnings growth and inflation (due to the current economy, over-all economic debt levels, maturity of expansion, etc.). Using 4% for growth would be defensible in my opinion, but let’s plug in 5% instead. Lastly, let’s factor in some assumption for valuations. Currently, the stock market is overvalued by most metrics. Maybe it’s a little overvalued by some measures; significantly overvalued by others. Let’s haircut our expected return by 1% (though that haircut might not be short enough). That total then is 2% + 5% – 1% = 6%. This is below the long-term stock market return (pick your long-term time frame) of 8-12%.

Adding it all up, it looks like bonds should yield 3% or more (given the assumption some additional yield can be attained by buying non-government bonds) and the returns for stocks should be approximately 6% or less. Given current valuations, stocks should outperform bonds moving forward, as they usually do. However, bonds usually have a quarter to a third of the volatility of stocks. For balanced portfolios managed to maximize total return for a given level of risk, bonds still make sense.

So, if stocks and bonds are priced to deliver below-average returns, what should investors do?

1. Trust the advice they’re getting. As a Vanguard white paper recently estimated, advisors can add 3% per year in value to investors.
2. Save more. With returns expected to be lower, many investors will need to save more to reach their financial goals.
3. Invest now. A correction is indeed due. It has been for a while now. We may get one soon, or we may get a lot later from now. Either way, stocks and bonds are still priced to deliver far superior returns than holding cash. Long-term investors should invest now, or at least start moving that way.
4. Stay balanced. Balanced portfolios work. The middle road may not be the fast lane, but it will get you to where you need to go.
5. Stay the course. There always seem to be trials, challenges and opportunities for investors to overcome or to resist. If a reasonable plan has been established though, and a reasonable portfolio has been built, staying the course is typically the right answer.

0663-CLS-4/1/2014