Vanguard Group's outlook for various traditional asset class returns

[SeattleCPA]

In case others follow their projected return forecasts, Vanguard published their end-of-year forecasts for next ten years a few days ago:

https://advisors.vanguard.com/insights/article/series/market-perspectives#projected-returns

The nominal return range they've giving for next decade for U.S. equities is 2.8%–4.8% with 16.9% volatility.

Their model forecasts inflation of 1.9% to 2.9%.

Sort of, then, a real return of 3.8% pre-inflation... and 1.4% after inflation.

[GilesMM]

Economists are famously terrible at predicting future financial behavior so I normally ignore predictions. Especially about the future!

[tooqk4u22]

Its kind of intuitive and certainly will be wrong.

Current PE and forward PE of S&P 500 is about 3.5% and 4% respectively (in line with the 2.8% - 4.8% range cited).

International has been in the crapper for ever, so just like every year for the last decade it "has" to out perform...I wish. Vanguard PE currently equates to 6.4% (below the 6.9% - 8.9% range that was cited)

US markets are pretty hot right now and also account for far more of the global markets than ever before, and yes it has a lot to do with the growth story.  Aside from the possible catch up trade from international I wonder three things:

1. Does the imbalance in flow of funds to US assets create more tensions globally?  And not just with the usual suspects like China, at some point the Eurozone will want some spoils too I suspect.
2. If the war between Russia and Ukraine ended, would Eurozone markets rally significantly because of the fear of an expanded conflict due to proximity would go away?
3. So much of the capital markets has moved offline and outside of regulation and oversight - private equity, private credit, crypto, etc. that I wonder if or when that will be a problem.

I think more troubling signs right now are the robber baron'esque political environment and hostilities on immigration will create significant problems at some point. 

We need population growth and we need immigration to do that. 

F*&K Elon Musk and Bezos and all the other mega billionaires that have too much influence, I mean for F*&K's sake Musk wants EV credits to go away, not because its makes the Dumberment more efficient but because he knows it will be crippling to other EV manufacturers and he is betting that Tesla can ride it out and be last one standing.  The rise in the stock price makes no sense from a price point that made no sense other than expectations of political favorability. 

[YttriumNitrate]

Nobody knows nothin'.

If only we could harness the power of Jack Bogle spinning in his grave it would surely go a long way in the fight against climate change.

[ChpBstrd]

Observation 1:
I tried to find the 2014 version of this forecast, to see if Vanguard was similarly bearish prior to a period of very good returns. I found this paper from 2012, which was published right before a ten-year period with a >10% annualized nominal return and a 7.5% real return, per the DQYDJ calculator. The paper used the historical predictive power of several metrics / valuation strategies to generate the probability ranges in the histogram below.

Overall, it's hard to say whether or not they made a good prediction. Actual nominal and real returns both occurred within the range of their top 3 bands, but each of those bands is 4% wide so guessing right within such a 12%-wide range was perhaps a soft pitch. In terms of 10-year annualized returns, there's a world of difference between a decade at 0% average annualized returns, and a decade at 12%, but each of those outcomes falls within the central set of probability bands on their histograms. One could argue they missed because 4-8%, both nominal and real, was the guess they considered most likely.

Of course, we know why they missed. Valuations expanded back into the range of the dot-com bubble. That probably can't happen again (i.e. Shiller PE can't likely increase 86% again, as it did between 2012 and today. That would imply an unprecedented Shiller PE of 72 a dozen years from now, which could probably only happen if inflation was extreme. The trailing PE ratio doubled between 2012 and 2024. So maybe their methods were sound but investor behavior was less rational?

Observation 2:
Vanguard is actually a slight bit bullish on ex-US equities and bonds, and yet foresees ten-year U.S. inflation of 1.9%-2.9%. If U.S. inflation stays under control, but U.S. stocks languish, then that scenario probably means that valuation factors like PE/1 and Shiller PE are driving their forecast. These are the same factors Vanguard found had the most predictive power in their 2012 paper.

Given that their 2012 paper was only wrong to the extent an unforeseeable expansion in valuations occurred, and given that another such valuation expansion is unlikely to occur if inflation stays low, we can conclude that Vanguard is on solid theoretical ground.

Recall that the mid-to-late 1990s had a negative real return over the next ten years, and it was largely because of valuation. S&P500 PE's were in the 25-30 range back then. Today's S&P500 PE is 31. Shiller PE's back then were in the range of 25-44. Today it is just under 39.

[ChpBstrd]

On a related note, money is flowing into the US and USD from other countries at a very fast pace. Per sources quoted in this article,

U.S. companies now account for 70% of the leading global stock index, up from 30% in the 1980s, while the U.S. economy's share of global GDP is just 27%,

Indices that weight stocks by price instead of market cap and adjust for the leading tech giants show that the U.S. has outperformed the rest of the world by more than 4-to-1 since 2009, he explained.

And such outperformance isn't restricted to stocks either. In 2024 alone, $1 trillion in foreign capital has poured into U.S. debt markets, nearly double what the eurozone has attracted. And America controls more than 70% of the global market for private equity and credit.

"In the past, including the roaring 1920s and the dotcom era, a rising US market would lift other markets," Sharma wrote. "Today, a booming US market is sucking money out of the others."

This reflects how ex-US markets are selling at a fraction of U.S. market valuations. The world MSCI index forward PE is 18.7, and the MSCI ex-US forward PE is 13.7, which looks very good compared to the S&P500's forward PE of 22.3.

I'm sure the Vanguard analysts were looking at this massive valuation gap when they predicted that the performance of ex-US stocks will be almost double the performance of US stocks. The capital flows propping up US valuations might not last a decade - that's the theory anyway.

[Radagast]

Of course, we know why they missed. Valuations expanded back into the range of the dot-com bubble. That probably can't happen again (i.e. Shiller PE can't likely increase 86% again, as it did between 2012 and today. That would imply an unprecedented Shiller PE of 72 a dozen years from now, which could probably only happen if inflation was extreme. The trailing PE ratio doubled between 2012 and 2024. So maybe their methods were sound but investor behavior was less rational?

Schiller PE adjusts for inflation.
I kinda expect it to happen: a huge US bubble that puts US CAPE higher than 1989 Japan. Or at least I consider that in the realm of very real possibilities.

I've read repeatedly for the past years that US stocks have been outperforming international stocks, but the major causes (not the only causes) are currency flows and multiple increases (P/B, P/S, P/E).

[ChpBstrd]

International has been in the crapper for ever, so just like every year for the last decade it "has" to out perform...I wish. Vanguard PE currently equates to 6.4% (below the 6.9% - 8.9% range that was cited)

Out of 9 possible asset categories, and over the past 15 years,

Developed Ex-US Equity: has been in the top-3 returning asset categories for 9/15 years or 60% of the time
Emerging Market Equity: has been in the top-3 returning asset categories for 9/15 years or 60% of the time

US large caps were in the top 3 the exact same percentage of the time, even though their total returns up until now were much higher!

Seems reasonable for Vanguard to expect ex-US assets will remain prominent on the Callahan periodic table in the coming 10 years, due to their better valuations.

[tooqk4u22]

International has been in the crapper for ever, so just like every year for the last decade it "has" to out perform...I wish. Vanguard PE currently equates to 6.4% (below the 6.9% - 8.9% range that was cited)

Out of 9 possible asset categories, and over the past 15 years,

Developed Ex-US Equity: has been in the top-3 returning asset categories for 9/15 years or 60% of the time
Emerging Market Equity: has been in the top-3 returning asset categories for 9/15 years or 60% of the time

US large caps were in the top 3 the exact same percentage of the time, even though their total returns up until now were much higher!

Seems reasonable for Vanguard to expect ex-US assets will remain prominent on the Callahan periodic table in the coming 10 years, due to their better valuations.

Not to quibble but I did say last decade, and durring that time Dev ex-US was ahead only two years and severely lagged returns those other years.

Also I think your 9/15 is combining Developed and Emerging as I only count 5/15 (33%) each for developed and emerging for top 3 performers.

Large cap 9/15
Small Cap 7/15

But yeah, you would think at some point flows would have to find their way to international simply for the relative cash on cash return (i.e. PE). 

[MustacheAndaHalf]

International has been in the crapper for ever, so just like every year for the last decade it "has" to out perform...I wish. Vanguard PE currently equates to 6.4% (below the 6.9% - 8.9% range that was cited)

Out of 9 possible asset categories, and over the past 15 years,

Developed Ex-US Equity: has been in the top-3 returning asset categories for 9/15 years or 60% of the time
Emerging Market Equity: has been in the top-3 returning asset categories for 9/15 years or 60% of the time

US large caps were in the top 3 the exact same percentage of the time, even though their total returns up until now were much higher!

Seems reasonable for Vanguard to expect ex-US assets will remain prominent on the Callahan periodic table in the coming 10 years, due to their better valuations.

You're comparing equity to fixed income.  Three of those asset classes are U.S. fixed income, global ex-US fixed income, and cash.  Equities should regularly beat cash, because equity involves higher risk and higher return than cash.

Since equities are expected to outperform, the 4 equity assets should outperform (U.S. large, U.S. small, developed, emerging).  But if there's only 4 equity categories, is it meaningful to take the top 3?

After a company bought Portfolio Visualizer, it didn't take long for the service to decline.  Which means currently, it only provides the last 10 years of data.  Over those 10 years, a $10k investment in the U.S. market returned $33k versus $16k for ex-US equities.  That winds up being about 13% and 5.5% per year, respectively.

U.S. big tech companies have beaten the market for 20+ years, making a significant contribution to U.S. equities outperforming the rest of the world.  These tech companies have significant weight (30%) in the S&P 500, which greatly increases the overall market's P/E ratio.  I don't know if that's the entire explanation, but when predicting future returns off of P/E or cyclical P/E (CAPE), big tech companies seem to play a significant role.

[BicycleB]

Noticed the huge gaps in projected returns of different asset classes in Vanguard’s September report and am embarrassed that I didn’t post a question about them. And now you’ve already brought up the topic (via valuations), and now there’s worthwhile discussion about it. Many thanks to all contributors.

[SeattleCPA]

Economists are famously terrible at predicting future financial behavior so I normally ignore predictions. Especially about the future!

Two things:

1. You need to use some value for planning.

2. Some of the people who reject a forecast based on formulas are actually just using simpler forecast: That the future will look like the past.

[SeattleCPA]

Nobody knows nothin'.

If only we could harness the power of Jack Bogle spinning in his grave it would surely go a long way in the fight against climate change.

I probably read most of Bogle's books. And because we were both authors writing for Wiley & Sons, I even had a tiny, tiny, tiny bit of contact with him about books. Thus I'm pretty familiar with his published and public commentary. What ChatGPT describes (copied and pasted below) matches my memory and sense of his positions...

Here's a summary of how he felt about the last time PE ratios were this high and his approach to estimating returns:

John Bogle, the founder of Vanguard Group, did caution about sky-high equity valuations during the late 1990s. He was known for his straightforward and data-driven approach to forecasting long-term returns, often using variations of the **Gordon dividend discount model** and considering other valuation metrics like the price-to-earnings (P/E) ratio.

### **Bogle's Methodology for Forecasting Returns**

Bogle's formula for estimating long-term stock returns involved three key components:

1. **Dividend Yield**: The starting dividend yield of the market.
2. **Earnings Growth**: The expected growth in corporate earnings, which typically aligns with GDP growth over the long term.
3. **Valuation Changes**: The potential change in the P/E ratio (or market valuations) over the forecast period. If P/E ratios are above historical norms, Bogle suggested caution about the potential for mean reversion, which could drag future returns lower.

Thus, his formula was roughly:
\[ \text{Total Return} = \text{Dividend Yield} + \text{Earnings Growth} + \text{Impact of Valuation Changes} \]

### **Applying Bogle's Formula to Today's Market**

Using today's numbers (as of late 2024), we can apply Bogle's framework to estimate potential future returns:

1. **Dividend Yield**: The S&P 500's dividend yield is approximately **1.5%**.
2. **Earnings Growth**: Historically, real earnings growth aligns with long-term GDP growth, which might be **2% to 2.5%** in real terms, plus inflation of around **2%**, giving total nominal earnings growth of **4% to 4.5%**.
3. **Valuation Changes**: The current P/E ratio is around **20 to 22** (based on forward earnings), higher than the historical average of **16 to 18**. If the P/E ratio reverts to historical norms over the next decade, it could reduce returns by around **1% to 2% annually**.

Putting this together:
\[
\text{Expected Return} = 1.5\% + 4\% - 1.5\% = \text{4.0\% annually (nominal)}
\]
This suggests relatively modest returns going forward, consistent with Bogle's earlier warnings when markets were highly valued.

### **Late 1990s Commentary**

In the late 1990s, during the dot-com bubble, Bogle frequently warned investors about excessive valuations. He argued that speculative enthusiasm had driven P/E ratios to unsustainable levels. His forecasts at the time were in stark contrast to the prevailing market optimism, and subsequent corrections in the early 2000s proved his caution justified.

### **Relevance Today**

Bogle's insights remain highly relevant in today's market, particularly when investors face low dividend yields and elevated valuations. His framework underscores the importance of tempering expectations and focusing on low-cost, diversified, long-term investment strategies to weather periods of low returns.

[tooqk4u22]

I am in the bogle camp and specifically I am a big believer in reversion to the mean, which can occur with higher growth rates in GDP/Earnings, a decline in valuations, or simply passage of time such that things catch up (i.e. flattish for a period).

One thing that has to be factored into the dividend yield is stock buybacks as they are basically untaxed dividends - buybacks would add another 1-1.5% to the yield.

Off topic on that note, I am fine with buybacks but I feel that executive compensation should not be allowed to be based on EPS or if they are should be based on pre-buyback share counts. 

[vand]

Of course Vanguard will be wrong (like everyone else), however its telling that we are at the stage where they are saying US equities will likely underperform US bonds:

US Equities:               2.8% – 4.8%
U.S. Treasury bonds:   4.1% – 5.1%

[ChpBstrd]

I am in the bogle camp and specifically I am a big believer in reversion to the mean, which can occur with higher growth rates in GDP/Earnings, a decline in valuations, or simply passage of time such that things catch up (i.e. flattish for a period).

One thing that has to be factored into the dividend yield is stock buybacks as they are basically untaxed dividends - buybacks would add another 1-1.5% to the yield.

Off topic on that note, I am fine with buybacks but I feel that executive compensation should not be allowed to be based on EPS or if they are should be based on pre-buyback share counts.

Dividend-related stock valuation models have been obsolete for decades because buybacks are such a superior method for companies to return value to shareholders. There are high-dividend, no-buyback companies out there, but you question the sanity of management when they choose the path that involves paying more taxes (as investors) and having less financial flexibility (due to investor expectations that dividends be constant).

Basically, the modern meaning of a dividend is "We in management don't think our stock is worth buying back at these prices, so we'd rather have the after-tax cash." Maybe if management doesn't think the stock is worth buying back, we should not think the stock is worth buying.

That's a different perspective than existed in the heydays of Graham or Bogle, as buybacks were essentially illegal prior to 1982.

Unfortunately, there is no good way to incorporate a "buyback yield" alongside the "dividend yield" because buybacks are usually less regular than dividends. This is good for companies (as they can change their buyback policies to adapt to conditions) but bad for dividend valuation models.

[Wintergreen78]

Thanks for this discussion. I’m much more of a set it and forget it person, but it’s given me some food for thought as I get closer to my “real” retirement (I quit working for about 3 years, and have been back at work for the last 4). I expect I’ll be able to retire for real in the next couple of years.

I’ve had an 80/20 split of stocks/bonds, with my stocks ~45% SP 500, ~20% small/mid cap US index, and ~15% rest of world index. For the last 10 years the others have lagged the SP500, so I’ll be pretty happy if these forecasts point in the right direction and they help smooth out returns for the next 10 years!

Also, I have a 7% mortgage. If these projections are anywhere close to correct, prioritizing paying off my mortgage is likely to be one of the best returns I can get in the short/medium term, even after accounting for the tax benefits of it.

This discussion has also given me some thoughts about shifting more heavily to bonds and the bond tent strategy for the first 5-10 years of retirement.

I agree with a lot of what’s been said. I take any of these forecasts with a big grain of salt. If I was 10+ years from retirement, I’d invest almost completely in equities and ignore them. But, when you are close to or at the beginning of retirement, thinking about risk and the sequence of returns for the next 10 years seems prudent to me.

[shinn497]

This seems correct, and in line with what PWL capital has also been projecting.

US large cap stocks have been great, but their high P/Es mean the data say they are less likely to be great in the future. The possibility exists, sure, but not relative to other asset classes.

I have a Betterment portfolio, and I kept the value tilt. I actually want to bias it a bit more to small cap, but it is ~40% in international stocks and I am keeping it there.

[vand]

There's a interview with David Rosenberg on latest Animal Spirits podcast, who's a fairly well known bearish-slanted defensive money manager and gives us his latest views on the S&P

- despite the 30% price rise, earnings have actually come in below expectations from a year ago (8.5% Vs 11%)

- earnings would have to grow 20%/yr for the next 5 years to justify current prices

- the equity risk premium right now is basically saying stocks are as safe as bonds

- Everyone is all in on US stocks.

Yes the S&P has made fools of everyone who's been bearish on it over the last few years, but the hurdle keeps getting higher and it will needs to continue to pull ever bigger rabbits out of the hat to keep up it's remarkable run.

[ChpBstrd]

To me, this chart suggests analysts have had a bearish tilt for a long time.

[vand]

To me, this chart suggests analysts have had a bearish tilt for a long time.

Interesting chart.. though I am not exactly sure what it's showing.. are the blue lines generally showing that analysts tend to overestimate future earnings most years and then revise them lower over the next 3 years..