2022 has been an ugly year for the markets. The total world stock market is down 17.5% and bonds are down 11.5%. But company earnings have grown 6% this year and bonds haven’t defaulted so what gives?
Discount Rates: The most direct answer is that “discount rates” used to value stocks and bonds have up. Discount rates are used to measure future cash flows in today’s dollars. The higher the discount rate, the less valuable those future cash flows are, so the lower the current value of the asset.
Expectations for future inflation has been a driver of the increase in discount rates. In the fixed income world, the federal reserve raising interest rates has been a major factor as well. With equities, the uncertainty of future profits because of inflation leading to higher production costs as well as recession fears, has led to higher discount rates.
Going forward, the Federal Reserve’s asset sale program will be a slow and methodical headwind to returns. Again, increasing discount rates by increasing the supply of the assets.
Effect on Future Returns: Fret not, there is good news. The phrase “discount rate” goes by another name, “expected return.” The returns we are expecting from stocks and bonds is significantly higher than it was at the start of the year. Back in January we were forecasting long-term returns from stocks to be around 7.5% and bonds to be 1.7%. Today, the expected return on stocks is up to around 9%, and bonds is at 4.0%.
Bond Returns: Coming up with an expected return from Fixed Income is relatively simple, use current yield. Presently, the Aggregate Bond Market is yielding 4.0%, short-term corporate bonds are yielding 4.3%, and municipal bonds are yielding 3.4%. High-yield bonds are yielding a whopping 8.4% putting them at a historically attractive valuation.
Stock Returns: Forecasting returns from stocks is much more challenging. Over the last 100 years, U.S. Stocks have returned 10% annually. Over the last 25 years it’s been 8%. One metric for stock market performance is looking at return stocks have had in excess of a riskless return (the risk-free rate). Some view the risk-free rate as inflation, others as one-month treasury bills, some as longer-term treasury notes. If you take the average of these, stocks do 6.2% better than the “risk-free rate.” Currently, the one-month treasury bill is yielding 2.6%, the five-year is yielding 3.4%, and CPI is expected to be 2.3% over the next 30 years. A 6.2% equity risk premium over the average of these risk-free rates, yields an expected return from stocks of 9%.
Another approach is to look at forecasted company earnings discounted back to today. If we use equity analyst estimates for earnings and a repeat of historical real earnings growth we can solve for the discount rate to justify the current price of the market. One variable with this approach is how many years you choose to discount. If you discount the next 30 years of earnings you get an expected return of 8.9%. If you discount the next 200 years of earnings you get 10.7%. There isn’t a good reason not to use the longer figures if you believe the stock market and capital markets will exist in a capacity similar to today. This approach does lead to higher valuations. Most investors struggle to forecast beyond 30 years which causes us to err on the shorter side of the forecasting.
Either way you come at it, an expected return of 9% from equities over the coming few decades seems reasonable. If that turns out to be accurate, one thing we know is that we won’t get 9% each year, the ride will be bumpier.
Take Away: The message continues to be the same as it was earlier this year, the market has been ugly, but the returns we’re expecting from it going forward are significantly better leaving most investors’ financial plans as well off as they were at the start of the year.
Rialto Wealth Management is a fee-only, fiduciary, advisory firm based in Syracuse, NY. From financial planning to investment management, we help families across New York and beyond. We can be reached by phone at (315) 992-9129 or via email through our website’s secure and confidential contact page.
Forecasting Expected Returns
September 9, 2022 by Ethan Gilbert
2022 has been an ugly year for the markets. The total world stock market is down 17.5% and bonds are down 11.5%. But company earnings have grown 6% this year and bonds haven’t defaulted so what gives?
Discount Rates: The most direct answer is that “discount rates” used to value stocks and bonds have up. Discount rates are used to measure future cash flows in today’s dollars. The higher the discount rate, the less valuable those future cash flows are, so the lower the current value of the asset.
Expectations for future inflation has been a driver of the increase in discount rates. In the fixed income world, the federal reserve raising interest rates has been a major factor as well. With equities, the uncertainty of future profits because of inflation leading to higher production costs as well as recession fears, has led to higher discount rates.
Going forward, the Federal Reserve’s asset sale program will be a slow and methodical headwind to returns. Again, increasing discount rates by increasing the supply of the assets.
Effect on Future Returns: Fret not, there is good news. The phrase “discount rate” goes by another name, “expected return.” The returns we are expecting from stocks and bonds is significantly higher than it was at the start of the year. Back in January we were forecasting long-term returns from stocks to be around 7.5% and bonds to be 1.7%. Today, the expected return on stocks is up to around 9%, and bonds is at 4.0%.
Bond Returns: Coming up with an expected return from Fixed Income is relatively simple, use current yield. Presently, the Aggregate Bond Market is yielding 4.0%, short-term corporate bonds are yielding 4.3%, and municipal bonds are yielding 3.4%. High-yield bonds are yielding a whopping 8.4% putting them at a historically attractive valuation.
Stock Returns: Forecasting returns from stocks is much more challenging. Over the last 100 years, U.S. Stocks have returned 10% annually. Over the last 25 years it’s been 8%. One metric for stock market performance is looking at return stocks have had in excess of a riskless return (the risk-free rate). Some view the risk-free rate as inflation, others as one-month treasury bills, some as longer-term treasury notes. If you take the average of these, stocks do 6.2% better than the “risk-free rate.” Currently, the one-month treasury bill is yielding 2.6%, the five-year is yielding 3.4%, and CPI is expected to be 2.3% over the next 30 years. A 6.2% equity risk premium over the average of these risk-free rates, yields an expected return from stocks of 9%.
Another approach is to look at forecasted company earnings discounted back to today. If we use equity analyst estimates for earnings and a repeat of historical real earnings growth we can solve for the discount rate to justify the current price of the market. One variable with this approach is how many years you choose to discount. If you discount the next 30 years of earnings you get an expected return of 8.9%. If you discount the next 200 years of earnings you get 10.7%. There isn’t a good reason not to use the longer figures if you believe the stock market and capital markets will exist in a capacity similar to today. This approach does lead to higher valuations. Most investors struggle to forecast beyond 30 years which causes us to err on the shorter side of the forecasting.
Either way you come at it, an expected return of 9% from equities over the coming few decades seems reasonable. If that turns out to be accurate, one thing we know is that we won’t get 9% each year, the ride will be bumpier.
Take Away: The message continues to be the same as it was earlier this year, the market has been ugly, but the returns we’re expecting from it going forward are significantly better leaving most investors’ financial plans as well off as they were at the start of the year.
Rialto Wealth Management is a fee-only, fiduciary, advisory firm based in Syracuse, NY. From financial planning to investment management, we help families across New York and beyond. We can be reached by phone at (315) 992-9129 or via email through our website’s secure and confidential contact page.