Cliff Asness: Be Realistic About 2.5% Real Returns
Cliff Asness had a great interview with Steve Forbes back in April (a copy is here) that highlights the dilemma facing investors today: stocks and bonds are overpriced, so what do you do?
…Looking at stocks and bonds, are they both overpriced?
Asness on market valuations:
Yeah, they are…if you’re going to say, “what are the next 10 years going to look like?”…value has some power to forecast the next decade…right now my favorite measure of value…is Bob Shiller’s PE. It’s gotten very popular. I’ve been looking at it since the late 90s. And that’s about the 85th percentile expensive back to 1926, so only 15 percent of the time has it been more expensive. It’s occasionally been way more expensive, so percentiles…people can use them to be tricky. Statisticians have all kinds of tricks…We’re at 25 on the Shiller PE. The 100th percentile, hit in early 2000, was 45…I would not call this a bubble, I would just call this an expensive market.
Asness on real yields:
The real bond yield…that’s just the 10-year bond minus our best guess of what economists are forecasting for inflation. I say “our best guess,” because we have their actual guess for 20, 30 years, [but] databases don’t exist and we have to guess at what they were guessing before that, but that’s also about the 85th percentile. The difference between them is relatively normal. People focus on bonds because it feels much more measurable. And yields are [low]…[this is] not a commercial for bonds…85th isn’t so good.
Both [stocks and bonds] are very similar [at the 85th percentile]…For truly long term investors, I would not use this to time the market…I still think returns will be positive. So if you’re out of the market for the next 10 years, that’s not going to help, and I don’t think you’re going to get the exact timing right. But I would lower my expectations. Whether you’re a pension plan, or an individual with a sheet of paper trying to figure out, “how much do I need to retire?” if we are right that these higher than normal prices, [and] lower than normal yields, are going to lead to positive, but lower than normal returns, well, you have to use those.
We think a 60/40 portfolio of U.S. stocks and bonds has averaged about 5% over inflation historically. We think, even if valuations stay high — and it could be worse if valuations fall, right? Regression to the mean. If those PEs come down, it could be worse — but even if they stay high we think they…offer 2 to 3 percent over inflation.
…You’ve said two and half percent real return. That sucks!
…You are obviously well-versed in the technical quantitative terms, but yeah, versus history, that sucks…It’s actually about the worst ever, and if you heard me, I said bonds are 85th and stocks are 85th, neither were the worst ever, but what’s particularly rare is both are in the 85th percentile at the same time. Even in the peak of the tech bubble, where stocks made a new 100th percentile bad in terms of valuation…(they made a new 100th percentile every day), bonds were offering you a fat 4% real yield on government bonds just for showing up. So very often these things are at least to some degree offsetting.
Right now we have a time where I don’t think (and some disagree) that there is a tremendous trade in or out of stocks versus bonds. And I don’t think you want to sell them both if you are long term because timing that is not an easy exercise. You’re very likely to hurt yourself…I think more likely than to help yourself. I think the best to do is, yes, it might suck, but it’s still positive, and it’s still the deal that we’re being given.
Asness reiterating opportunity costs:
…If something “sucks,” but it’s the best deal out there, the one thing you don’t want to do is ignore the bad news. Have a sheet of paper that says, “I can retire,” (and by the way, pension funds do it in a more sophisticated way with actuaries and other things, but it’s not that different than individuals with a spreadsheet or a sheet of paper), “[so] what do I have to earn on these assets to meet my needs?” If you don’t acknowledge the 2.5% real, and you don’t have to agree with my precise numbers, but if you don’t acknowledge that these are expensive, and going to return less, and go, “well, I think inflation is going to be more like 3%, and they’re going to make their normal 7% real, so I think [a 60/40 portfolio is] going to make 10% going forward”…If you use that and it doesn’t happen, that’s where the trouble lies.
So I think this stuff, while it might be depressing, and not useful to jump in and out, is actually quite useful for making your plans, because you know what you gotta do…and the world, sadly, is up against a harder challenge than it normally is.
What’s the bottomline?
Unicorns, fairy godmothers, and trolls all exist in fantasyland.
Similarly, 10% annual returns–without exceptional risk–likely exist only in fantasyland.
Maybe we should all be planning for reality, but hoping for a fantasy…?
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