The Weekly Orb: High Valuations and Low Yields

One of the themes of the Weekly Orb over the last few years has been a discussion on high
valuations in the stock market and the impact of high valuations on future stock market returns as
well as the impact of high valuations on stock market declines during recessions.
Several times I have posted the chart below from GMO (a large money management
organization) on expected returns from various asset classes over the next 7 years.
The returns shown below are real (after inflation) annualized returns. The S&P 500 is the green
bar on the far left side labeled US Large. GMO is projecting a negative 1.2% annualized real
return for the S&P 500 over the next 7 years. GMO is also projecting a negative 1.4% real return
for the US Aggregate Bond Index over the next 7 years.
Even Bogle is in the very low return camp for the next decade, although his return is not as low
as GMO. The GMO projection is in the same ballpark as the Research Affiliates (Rob Arnott)
forecast.
There is no legitimate asset class forecast that has stocks or bonds having a high return over the
next 7 to 10 years.

Even though I knew that neither stocks or bonds could have high returns over the next 7 to 10
years I did not realize just how much of an outlier the current conditions were until I saw the
chart below.
This chart takes effort to understand, but it is well worth the effort.
The horizontal axis is the yield on the 10 year Treasury. The vertical axis is the Shiller PE. Each
dot represents the starting yield on the 10 year Treasury and the starting Shiller PE for each 10
year period from 1881 to 2015.
The color of each dot represents the return over that ten year period from a portfolio of 60%
stocks and 40% bonds.
The highest dot represents the decade from 2000 to 2010. At the start of the decade (in 2000) the
yield on the 10 year treasury was a little less than 7% and the Shiller PE was close to 45. The
return for the 60/40 portfolio over that decade was 2.28% annualized and the color of the dot was
red. The return legend is on the right of the chart.
As might be expected the highest return for a 60/40 portfolio was 1982 to 1992 when stock
valuations were at a low and interest rates were at a high. Over that decade a 60/40 portfolio
returned 16.45% annualized.
The 2015 to 2025 dot is shown on the chart because we know the starting valuation and the
starting yield.
Here is the situation. With the exception of the ten year period 2014 to 2024 (the dot to the left of
2015 to 2025) there has never been a period in the last 135 years when stock valuations have
been this high with bond yields this low.
It is entirely possible with this combination of high valuations and low yields that a 60/40
portfolio might have a zero or negative nominal return over the next 10 years.

Which goes to the point I have made repeatedly over the last few years.
How well you do as an investor over the next ten years will have nothing to do with what you
own and everything to do with when you own it. Avoiding the next recession is likely to be the
defining event in portfolio success.