Looking backward and forward

Below are some interesting charts sourced from the Asset Allocation Interactive tool developed by Research Affiliates (1). These charts provide historical performance and forward-looking expectations for bonds and equities (distinguishing them by geographic exposure and investment style). All returns are real, in USD (2).

The expected returns produced by Reasearch Affiliates are modeled using both expected cash flows and changes in asset prices, not by extrapolating past returns. More info about their methodology for valuing assets here.

Figure 1 – Bonds Return vs Risk

The two charts above show the past and future volatility-adjusted returns of aggregate bonds (corporate and government) for the US, ex-US, and global market. Bond returns have been poor in real terms over the past ten years, while the 10-year forecasts indicate an upward trend. This suggests that, going forward, bonds may once again play a more attractive role in diversified portfolios, both for income and risk mitigation.

Figure 2 – Equity Return vs Risk

Figure 3 – Equity Returns

Here above both trailing 10Y and expected 10Y real returns on equities. Trailing returns confirm the supremacy of US big caps in recent years, which in turn pulled up the developed and all-country equities. In terms of market capitalization, we observe a cluster with higher Sharpe ratios among large caps, and a cluster with lower Sharpe ratios among small caps.

Looking at future prospects, it is clear how the two clusters swap, and one can expect a better risk-return profile for small caps rather than large caps. In terms of geographical exposure, expected real returns are much lower in the US and much more attractive outside the US. The expected 10Y returns suggests a reversal in trends: ex US equities (especially small caps) are expected to deliver superior real returns compared to US large caps (approx 6% excessive return). This is likely due to more attractive starting valuations and greater growth potential in smaller companies.

Figure 4 – Style Equity Return vs Risk

Figure 5 – Style Equity Returns

Moving on to investment styles, the dominance of US large growth stocks in past returns is confirmed, with a future expected return that is even negative. The past underperformance of value stocks, on the other hand, is associated with a clear expected outperformance for value stocks (particularly ex US small caps) and emerging markets equities. In any case, none of this is new – the overvaluation of US large caps market in recent years is evident, as it has been for years. The issue is that the market can keep climbing for years, driven more by optimism and sentiment than by actual earnings. This leads to prolonged periods where returns are disconnected from underlying earnings growth.

The data suggest that a diversified approach, including exposure to value and international equities, may enhance long-term risk-adjusted returns.

Figure 6 – Equity CAPE and Volatility

In figure 6 trailing and expected CAPE (3) and volatility for equities, plus some final remarks below.

• If all this is correct, in 10 years you’d feel foolish for not having diversified into bonds, emerging markets, ex-US, and small-cap/value equities. If all this is wrong, you’d feel foolish for having missed another decade of US and big cap dominance. In such contexts, it makes sense to consider factor investing, such as size and value, to hedge, but also momentum and trend following to ride irrational bull markets. Everyone should make their own assessments.
• Low P/E ratio does not automatically translate into higher returns or undervaluations. In many cases, a low P/E should reflect higher perceived risk – investors are discounting future earnings with higher rates. On the other hand, high P/E can indicate lower risk, but it may also point to overvaluation, excessive optimism, sentiment, speculation.
• Markets can stay irrational for a long time, so it’s wise to assess prices against fundamentals, at least from a qualitative point of view. Apart from dividend and buybacks, there’s no constraint between earnings and prices in the medium-short term – therefore, prices can be primarily driven by volume, sentiment, supply and demand dynamics for many years.

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(1) In general, assuming a 100% equity portfolio, exposure to a foreign currency increases volatility due to the exchange rate fluctuations. Over the long term, it has a neutral effect on returns, since the impact of currency movements does not provide a positive or negative expected return – currencies do not have a “risk premium.”

(2) The images and data are derived from a publicly accessible tool designed to help investors and researchers explore capital market expectations and historical outcomes. It is important to note that the information are provided by Research Affiliates, do not constitute investment advice, and may not represent actual future results. All content is used in accordance with the informational and non-commercial intent of the original source, and any conclusions drawn are my own interpretations based on the data presented.

(3) Recall that CAPE, also known as the Shiller PE, is calculated as the current price divided by the average earnings of the past 10 years. Generally, it measures whether the market is expensive or cheap (and not overvalued or undervalued) and has a certain correlation with long-term returns.