Skeptical About the Future

Is the market's future dim? Many say so. Multiple pension funds are ratcheting down their expectation of future returns. One particularly noteworthy fund is considering overhauling its asset allocation to better navigate market bumpiness. Some experts think new retirees should adjust how much they take from their portfolio because future returns look muted. While we don't know what market conditions will be many years from now-nobody does^[i]-that so many folks are convinced returns will be lower does say something about the present. In our view, investor sentiment still seems pretty skeptical overall, a view only reinforced by recent volatility, suggesting the bull has quite a bit of wall of worry to climb.

Now, sentiment isn't wholly skeptical-we've seen a fair amount of rational optimism. A collection of pundits interviewed by Barron's expects the S&P 500 price index to reach 2150 by year's end. This would mean a roughly 10% gain from the S&P's Thursday close and a 15% rise from the most recent low on August 25.^[ii] Sounds big, but it would actually be a near-perfect V-shaped correction recovery, which is fairly normal. So we'd call this rationally optimistic, not wildly so.

However, while optimism is budding for the near term, skepticism over stocks' longer-term potential hasn't faded. If anything, it's escalating. Many public pension funds are lowering their investment-return expectations, with an average target of 7.68%-the lowest in 26 years. The second-largest pension fund in the US is considering raising its allocation in hedge funds and "safer" investments^[iii] (e.g., long-term Treasurys), likely at the expense of some stock and corporate bond holdings. These big pension funds aren't the only ones expecting lower market returns, either. Some believe the rule-of-thumb 4% annual portfolio withdrawal rate for investors is too high-2% is the new "safe"^[iv] withdrawal rate.

Old false fears drive much of this skepticism, so to us, it says more about how folks feel than what stocks will actually do. For example, many point to allegedly high stock valuations-and especially the cyclically adjusted price-to-earnings (CAPE) ratio-as evidence markets' future returns will be subpar, suggesting lower returns would return valuations to their historical average (mean reversion). However, mean reversion isn't a thing for stocks, and valuations don't have predictive power. Historically, high valuations haven't predicted short- or long-run returns. At best, the forward price-to-earnings (P/E) ratio gives a rough way to measure sentiment. Ditto, to an extent, for trailing 12-month P/Es. CAPE, however, doesn't even tally sentiment loosely, because "cyclically adjusted" means blending decade-old, bizarrely inflation-adjusted earnings and comparing that to prices. We're sure folks had some feelings about earnings back in 2005, but that won't tell you much about earnings in 2015 or 2016, and that is a whole lot more relevant to how folks feel about stocks today.

Others point to slower global growth prospects-and wobbling Emerging Markets' potential impact on the US-that could trip up markets. While we understand why many connect economic growth and market movement, the two aren't correlated. GDP growth, the most common metric used to determine how a country's economy is doing, is a loose measure of the flow of a nation's economic activity-both private and public. A stock tells you the overall value of an individual business. To see why these aren't synonymous, consider any big US retailer that sells imported goods. GDP would count those imports as negative. But for the retailer, they're revenues and earnings. Without imports, the company would have no business-no value. And if quick economic growth alone determined market performance, an Emerging Market like China, which has enjoyed double-digit growth for much of the current century, should have the world's best-performing stocks. Yet Chinese domestic stocks ("A"- and "H"-shares) haven't correlated with either the economy's rapid growth or global stocks in general.

That said, we aren't discounting the possibility of lower future market returns. However, no one can know whether they will or won't be! Supply and demand are the two most critical factors for stocks. In the short term, demand holds most influence, since supply is relatively fixed. But in the long run, supply holds sway. However, we also aren't aware of anyone who can forecast what equity supply will look like in the long term-to our knowledge, no one has even attempted it. The furthest stocks look out is 30 months or so, and they focus most on the next 12-18 months.

In our view, broad investor sentiment doesn't appreciate the current market environment, which should allow the bull to keep charging ahead over that foreseeable future. Despite all the worries, the global economy is expanding. A couple high profile weak spots don't negate the many places-especially where service-oriented growth dominates-that are growing. Many developed market economies have gridlocked governments, and gridlock lowers the likelihood major, sweeping legislation-the type that alters property rights or impacts global commerce-passes without getting watered down or stopped outright. Yet many investors remain convinced the bull market needs central bankers' help. Or will crash from a Chinese hard landing. Or may slip on oil. But, in our view, these concerns are all well-known and/or aren't a big enough negative to wallop the bull. Some aren't even a net negative at all (e.g., oil).

That sentiment still remains pretty dour overall despite a smattering of rational optimism suggests investors are far from the blinding euphoria typical at bull market tops. While volatility has increased skepticism some lately, in time, the current correction could lead to optimism taking a firmer hold, with folks feeling as if the market has finally had its "overdue"^[v] shakeout. It may give them confidence the market has finally "dealt with" an issue they feared. With other market drivers still positive, that points to more bull market ahead, as stocks continue climbing the proverbial wall of worry.