The Long View: Timing is all during the Fed’s ‘tapering’ terror

Investment outlook is poor as both bonds and stocks are expensive

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Sometimes the long run is easier to forecast than the short. During the next decade, the odds are that returns will be very poor. The outlook is as bad as it has been in a century.

Over the short-term, however, anything could happen. For example, look at the reversals and turbulence in world markets over the past two weeks, largely led by nerves about a report on US jobs, which, when it was published on Friday, turned out to be exactly in line with the trend of the past 12 months. And so some investors warn of a disappointing decade ahead, but simultaneously entrust more money to the stock market.

The long run looks bad because, unusually, both bonds and stocks are expensive. Thus there is little point in big switches between bonds and stocks. This makes life hard for long-term investors such as pension funds.

The chart was produced by Cliff Asness, the founder of AQR Capital Management in New York. It shows what the forecast 10-year return, after inflation, would have been on a portfolio with 60 per cent in equities and 40 per cent in bonds at every point since the beginning of the last century. On this basis, the 10-year outlook has never been so gloomy.

How did he produce his forecasts? The intuition is simple. Over periods of a decade, equity returns are dictated in large part by how expensive they were at the outset, as measured by Cape (the cyclically adjusted price/earnings ratio), which compares share prices to their average earnings over the previous 10 years. When Capes for the US S&P 500 are at their lows, between 5.2 and 9.6, the average real return over the subsequent decade has been 10.3 per cent.

When Capes are at the top of their range (they hit 46 during the dotcom bubble), the average return has been 0.5 per cent. At present, the CAPE is 23.6. This is well above its historical average and implies an annual return of about 0.9 per cent over the next 10 years.


As for bonds, they have a long-term relationship with inflation. The expected real return is the yield on the 10-year treasury bond minus forecast inflation for the next 10 years. The resulting number has been close to zero for a while.

So long-term investors have few places to hide. Stocks look expensive relative to their own history, but less expensive than bonds – so there is no point in switching from stocks to bonds. Meanwhile, managers have little reason to move out of bonds, particularly when regulators are prodding funds to hold them.

What can we do about this? Mr Asness suggests that those wanting a return of 5 per cent must overcome squeamishness and resort to leverage and derivatives (to magnify returns from safe but boring trades) and selling short (to profit when security prices go down). Academics have identified enough long-term anomalies in stock markets that investors might have a fighting chance of getting to 5 per cent. For example, cheap stocks tend to outperform, while stocks with strong momentum tend to keep moving in the same direction.

Others similarly gloomy about long-term returns suggest simpler strategies can work. Jeremy Grantham, founder of the Boston-based fund manager GMO, suggests that assets are now “globally overpriced” but that prices are not being driven by bubble-like euphoria.

Mr Grantham expects demographic shifts to drive lower equity returns for the coming decades, but for the time being GMO is “modestly overweight” in stocks because they are less expensive than bonds. This has paid off.

Meanwhile, the absence of a bubble raises the possibility that one could inflate. This week’s events suggest how this could happen. Ahead of Friday’s US jobs data, the dollar sold off. Japanese stocks, which are harmed by a weak dollar and strong yen, suffered a true “bear market” 20 per cent fall in barely two weeks.

That volatility is driven by concern about when the Federal Reserve will start to withdraw (or “taper”) its support for asset prices. Such an event would strengthen the dollar. There was speculation about a weak jobs report, which would imply greater support for markets for longer, which should weaken the dollar.

With the release of the data, showing a steady but unimpressive US recovery still under way, speculation shifted to an earlier date for the start of tapering; September is now a popular guess, but many other dates are possible.

The lessons of the past week are that markets are terrified about the Fed’s eventual exit and that timing the market in the short run is a nightmare.

Tapering too late might create less risk of a dangerous market sell-off than tapering too soon. And hence the chances that the rally in stocks builds into a true bubble also increase. Anyone who could time this correctly might bank enough money to survive what follows.

But basic truths remain. It is easier to forecast the long-term than the short. And the long-term does not look good.

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