Mid Quarter Client Investment Update

Realistic Return Expectations – A Look at the Past to Project the Future

When asked for our thoughts and expectations for future rates of return and market volatility, our response begins with a look at what has transpired in the past. We most often refer to the following table that provides historical data for returns on stocks (the S&P 500 Stock Index) and bonds (Bloomberg U.S. Aggregate Bond Index). You’ll see from Figures 1 and 2 that stocks averaged 9.0% per year in the past 27 years while bonds averaged 4.1% per year.

Note that this 27-year period includes:

• the late 1990’s technology bubble (1996 to 1999)
• the tech bust (2000 to 2003)
• the Great Recession (housing bust 2007 to 2009)
• the COVID pandemic with a brief bear market and recession (2020)
• the surging market of 2021 fueled by excess liquidity and stimulus
• when interest rates were normalized in 2022, with both stocks and bonds being repriced to reflect higher interest rates

Another historical chart (Figure 3) from J.P. Morgan depicts rolling returns of stocks and bonds. As we have described in past meetings, the range of one-year outcomes can be very wide, while the long-term picture is driven by yields for bonds, and starting valuation levels and earnings growth for equities.

Going forward, we estimate 5-year average annual returns in bonds to be in the 4% to 5% range, which is in line with current rate levels. Equity returns are trickier to figure as common stocks represent ownership interests in operating businesses that are subject to economic cycles and numerous other factors. Additionally, equities are entitled to residual profits that can be reinvested, used to pay down debt, or returned to shareholders, while bonds have contractually agreed upon cash flows and maturities.

Even so, we expect the risk/return relationship evident in these historical figures to continue in the future, i.e. stock returns will exceed bond returns with higher volatility. In essence, stock prices move up and down, continually reflecting the market’s adjustments to expected future profits and the required premium (often referred to as the Equity Risk Premium) demanded by investors over risk-free rates of return (often determined by U.S. government debt).

Betwixt and Between – A Cautious Yet Opportunistic Time Period

The market decline last year repriced assets to more normal interest rates, which we welcomed, albeit with some discomfort. The economy has recently been performing better than most anticipated. Consumers, banks, and most businesses are in relatively good financial shape, which will mitigate the impact of a recession if one were to occur.

Our guess: Odds favor no recession during the first half of 2023 with risks rising thereafter. We have been, and plan on, remaining defensively positioned as we believe the near-term risks remain skewed negatively.

In the interim, as we continue to seek opportunities that market volatility periodically provides, we are buying bonds where appropriate at more palatable rate levels and searching for inflection points to get more constructive on equities.