Live webcast replay: Where are stocks headed next?
April 10, 2013
Replay and transcript from a recent Vanguard webcast
Even though stocks have performed well in recent years, many investors are still skeptical about the long-term prospects for stocks, especially with the challenges still facing the U.S. economy. In this live webcast that aired on February 21, 2013, Vanguard chief economist Joe Davis and Karin Risi of Vanguard Advice Services discussed the outlook for stocks, and why investors should view the long term when building their asset allocation.
Amy Chain: Good afternoon and welcome. Thanks for joining us for this special live Vanguard webcast. I'm your host, Amy Chain, and today we are going to be talking about a long-term outlook for stocks and what factors may or may not help us determine where these stocks are headed. Joining us today to talk about these topics are Joe Davis, Vanguard's chief economist and also Karin Risi of Vanguard Advice Services. Joe and Karin, thanks for being here with us today.
Joe Davis: Great to be here.
Karin Risi: Thanks for having us.
Amy Chain: Great. So we'll jump in, in just a minute but as always, this webcast is about you and your questions and we've already had lots come in. So if you have additional questions, we'll be taking them live today, so go ahead and send them through. We're also taking questions on Twitter, so if you're on Twitter and you have a question, feel free to send them through to #VGLive.
So before we jump in, I'd like to go to you, audience, and ask you a polling question, and that question is, "What is your outlook for the stock market? Are you feeling optimistic, pessimistic, or uncertain?" You should see that question pop up on the right-hand side of your screen now, so go ahead and weigh in and we'll be back in just a few minutes to look at the answers.
In the meantime, Joe, I'd like to talk with you. You are asked quite often for your outlook on the stock market. So maybe you could tell us a little bit about some of the factors that your team thinks are good predictors where the stock market may be headed and what those predictors are telling us today.
Joe Davis: Certainly, Amy, and as we clearly recognize when we talk—we talk a lot at Vanguard about portfolio construction and asset allocation, how important that is to our investment success. And one critical component of asset allocation is what the expected returns are for, say, stocks and bonds and other assets that we'll have in our portfolio, and so a reasonable question that always comes up is, "What are reasonable expectations for stock market returns?" since that can often be the most volatile asset in our portfolio. And so what we clearly did and have focused on this for several years, but the research we came out with last year actually did a very rigorous look at: Are there any other signals that we would know today, that we could look at in the newspaper and look online and clearly look at today that would have any association, has had any association, with future returns at a one-year horizon, three-year horizon, and importantly over longer horizons? And clearly what we found are twofold.
One is that over the—associated with next year, there's very little predictability or forecasting in terms of future stock market returns. To us, that's not surprising. It's why we really endorse a long-run perspective, which is contrary to what we may see in the media and in the press where we hear a lot of prognostications about, "Well I think the S&P's going to do that this year," and so forth. Quite frankly, there's not strong evidence that there's any reliable predictor that we would know.
Longer term, there is some association, some reasonable guide as to what can inform or influence expected returns for stocks and of all that research, the primary ones are what we call valuations. So we may be familiar with that in other terms such as price-to-earnings ratios, price- to-book ratios, dividend yields, those sort of things that have what we would call "fundamental intrinsic anchors" over long periods of time, and so based upon where valuations are today, which if you look at a whole range of P/E ratios, they're close to historical averages. And so when you do that, that would clearly be associated with close-to-historical-like returns over the next 10 or 20 years.
Yet we also have to acknowledge that the correlation or the association, the ability of valuations to relate with future returns, even in a ten-year horizon, is somewhat less than 50%, so 40%. So again, it can help inform and help guide what a reasonable essential tendency of returns are, but it certainly is not so definitive that it would give you one number. And so based upon those relationships today, we're in the high single digits as essential tendency over the next ten years acknowledging that there is a range on both sides of that arithmetic.
Amy Chain: So I think what I hear you saying is even some of the best predictors really only get us about 50-50 shot at predictability.
Joe Davis: Even less and again, that's over a 10-year period. This is going back over 100 years in the United States data. That has really no association, so where valuations today really give us very little, if any, insight of what stocks will do this year. And again, we would love to say more definitively, if they would. Quite frankly, the evidence is not there. And there's other factors we looked at that, quite frankly, get a lot of attention in the economists and investment community such as the expected growth for the economy, whether the dividend yield in the stock market versus, say, the ten-year Treasury, the so-called Fed model. That has very little, if any, association with future returns despite its popularity. And even things such as debt levels, which United States, at least today, it has had very little relationship with future returns. So we actually found that the rainfall, which is a pure weather variable that we just put in there just to test that it shouldn't have, that's about the same level predictability, which is effectively zero, with other things that are commonly associated with the media. So I think certainly it was a good lesson and reinforcement for me of why we take that long-term perspective and focus on the things that matter, but let's not put too much emphasis on thinking that we can define the future so definitively.
Amy Chain: Very interesting and I think that ties nicely to the results of our first polling question which are in. It looks like the vast majority of our viewers today say that their outlook is pretty uncertain. So, it's in line with what you are saying and also certainly in line with what we're all hearing and seeing in the news and in the papers.
Joe Davis: The other thing is, too, is just—things in the short horizon, things such as sentiment—so there's polls and surveys done in the investment community of how are investors—are they feeling more bullish or optimistic or perhaps more pessimistic? Ironically, again, at the margin they have very little bearing with future returns in one year. If anything, they're mildly negatively associated, correlated. So in other words, at the margin, if investors are more enthusiastic, that actually has been associated with, at the margin, somewhat lower than historical returns. So again, I think that's important to keep in mind to try to minimize the attention on momentum in the markets, recent performance of the markets. It's tough to do because it's very emotional and behavioral, but I think investors can be rewarded if they do that because it's not easy to do.
Amy Chain: If they can be rewarded, let's repeat it.
Joe Davis: Yeah, "if."
Amy Chain: "If" they can be rewarded. So thanks, audience, for weighing in on the question. We are actually going to come back to you with another question, and that question is, "Have you made changes to your portfolio based on your expectations for the stock market?" Your answer options are: "Yes," "No," or "Not yet, but I'm considering changes." Now, taking a look at some of the questions that we've seen come in ahead of time, I think I know where we're going to be headed with these, but Karin, maybe you can talk to us about Vanguard might suggest clients be doing in this challenging economic time.
Karin Risi: Yeah, well, I'll say I'll put in my vote that given that the first polling response was "uncertainty," I think this, the polling question, I'm going to guess, the response will be largely "considering making changes," and that's what we're hearing from many of our clients. So when you have such uncertainty and volatility, you have clients, especially for those where we advise their assets in an ongoing relationship, asking our advisors, "What changes do I need to make?" I suspect many questions we'll get today are around that, and it's tough because as rigorous as the research is from Joe's team—and it is rigorous—clients want greater specificity. When they want to know what the market's going to do, they want to know within the next 12 or 24 months, not what's the probabilistic range over the next ten years, even though that's as much as you can really rely on, and even that is less than 50% for some elements.
Joe Davis: Yeah. And I think it's important that we respectfully push back as a firm because I think it's somewhat disingenuous if we would just put one number because that would bely, or it would imply a certain precision in the future that just as human beings, we do not have in this world, in my opinion, and I don't think we will find that. So I think to not do so and to not frame that problem or this sort of question of outlook for stocks, or outlook for bond returns, or outlook for inflation, for that matter, in not a probabilistic way, I think can understate the uncertainty and risk associated with any outlook.
Amy Chain: Well that's interesting, and I think we should also take a look at some client responses. I actually don't see them coming through yet, but maybe we could talk in the meantime about if clients can't rely on certain aspects in the market, and if clients are feeling a little bit uncertain, what is it that we think they should do about that?
Karin Risi: Well, I think it's not new news, but we certainly would encourage clients to take a step back, take a look at your long-term plan—hopefully you have one. If you don't, it's an opportunity to say: How should you be allocated; What should your mix be among stocks, bonds, and cash?; Does your allocation meet your personal financial goals? Less about what do you think is going to happen in the market because we know that's fairly uncertain. It lacks a definitive nature, so you can think about what's going to change perhaps on your own personal time horizon in the next three, five, seven years. So, significant life events often trigger changes in a client's portfolio. We've spent our time with clients, Amy, really focusing on the things that they can control, thinking about tax efficiency and cost and asset allocation as the primary driver of returns, and asking them to really think about not altering their risk profile unless they're doing so in a conscious way.
Joe Davis: And I think just the point of emphasis on the financial markets, Amy, would be I think two areas where we would have a greater confidence in terms of probabilities or statistics over the next decade or so would be the probability that stocks outperform bonds, as best we can estimate, 75% or 80%. It's not 100%, and it never will be, but it remains a decent outlook for what some would call the equity-risk premium or the ability or the potential for stocks to outperform bonds. Now again, that would seem reasonable because stocks are inherently more volatile as we saw clearly in 2007, '8, and '9. And then secondly, the probabilities are higher that bond returns or a broadly diversified bond portfolio's going to have—could very likely have lower returns than it has in the past 10, 20, or 30 years, and that's something we've heard in other webcasts for two or three years. The ultimate maturity in the bond portfolio's a decent proxy for expected future long-run returns. So I think that is something that we could have a little bit more conviction in, so to speak. In my mind, that still leads to the core tenets of portfolio construction.
If one needs greater return, then one is going to have to take on more risk, that there's not a silver bullet or something. So in that regards, the tenets of portfolio construction, the more risk, the higher equity-like volatility you're going to have to bear as an investor I think just remain in place.
Amy Chain: And I think we're going to get into a lot of that once we start answering some of these viewer questions, but the results of our poll are now in and it looks like, surprisingly, the answer was pretty evenly split. "No, I have not made changes" won by a small margin. Thirty-seven percent said "no, we have not made changes based on the stock market." What do we think? Surprising? Sounds like maybe.
Karin Risi: I'm impressed, I'm impressed. Now I'm not surprised, right, because this is largely the viewing audience are Vanguard clients, so I think they do understand sort of the long-term nature of investing, but I wouldn't fault them if they did think that they needed to make changes, and maybe they do, right? It's a great opportunity to look at your portfolio and think about what changes might be required.
Amy Chain: Good, so gold star to you, audience, for not reacting with a knee-jerk reaction to stuff that's going on in the markets. So this is great. We've asked you guys—excuse me, we've asked you a few questions. Now I'd like to ask you a few questions from our clients. So let's start in with a question that comes from William from Alexandria, Virginia. William asks, "What's keeping the Dow and S&P so high other than low interest rates and continual QEs by the Fed? That is, is there real substance and strength behind the rise in equities, or is it just that there's no place else to put money and get a decent return?"
Joe Davis: It's actually a real good question. I mean, they generally are on these webcasts. I think again, looking back over the past several years, I recall doing a webcast, 2009, and during that time, I recall the difficulty in that environment, and our general outlook was, "Listen, the economic environment, more likely than not, in the United States and elsewhere, is going to be very, very challenging, and we're going to have a very subdued recovery." And then that said, one could have a decent portfolio return—now again, knowing the uncertainties in the markets. And the reason why we said that is—and again, it's based in part on the research that we've done—is much more important in economic growth, per se, for long-run stock returns is the price one pays for growth, so again, going back to valuations and so forth. So when you looked at 2009, 2010 valuations by some metrics—P/E ratios and others—were again at extreme levels relative to history, and so it was not surprising to us that we had a decent rebound in the equity markets. It wasn't certain. We did not know exactly the course, but I was not surprised to see that. So in that sense, I would say much of what we've seen has been a genuine rise, again, from a very virulent and pernicious downturn in the equity markets.
Now that said, no one has a definitive answer in terms of how much the Federal Reserve has influenced the market. Clearly they are trying to do so, so we all feel wealthier and may actually spend a little bit more. So I have some concerns of how much they may have influenced the equity markets, but that is not the sole reason, in my opinion, why we've seen the rise. I think part of that just has been that the equity market in 2009 was discounting a very, very severe economic downturn, and we've seen a modest progress since that time. And so with that, the equity markets are repricing into that more—a little bit more subtle recovery scenario.
Amy Chain: Thanks, Joe. Karin, I'm going to send one your way. This question comes from Doug in Montrose. This is Montrose, Colorado, in case anyone was wondering. "Are there circumstances where you would suggest changing your asset mix based on what you think the future of the markets portend?"
Karin Risi: So the answer is no, generally speaking, and this investor's question, believe me, we understand the allure, right. We get why—this amounts to market-timing, frankly. So based on what you think the market might do, do you want to switch your allocation among stocks, bonds, and cash in an effort to essentially time the market for a better return. And while we do understand why clients—they want to feel that activity—we are consistently persuaded by the data, and the data from Joe's group, which it's not that we're not game to look at it. We look at it again and again and again, and consistently what we find is market-timing—it doesn't produce benchmark-beating returns. So on average, can you be right? Yes, you can be right. Any investor can be right with a market-timing move. Can you be right twice? Because you have to know when to get out and then when to get back in. So it's a little more complex than most people may think, and we see a lot of clients get burned, frankly.
We advise a lot of clients at Vanguard, and many of them, for various reasons, some of them are not intentionally timing the market in an active way as much as they are sometimes getting out of equities, as we saw a lot in 2008, 2009, and then frankly not knowing how to get back in. So no, as I mentioned earlier, we focus on the items that you can control. We talk about if there's significant life events—think death, divorce, birth of a child or grandchild, a marriage— things like that that automatically should trigger an opportunity to look at your portfolio or, in fact, needs for large cash outflows—buying a home or a second home. Those are things that you can anticipate and prepare for, and that's a rebalancing opportunity or an asset-change opportunity, an allocation-change opportunity. We would caution investors against market-timing.
Amy Chain: So what I think I hear you saying is, don't necessarily change your portfolio because of the markets, but it may be okay if something in your life changes to take a look at whether or not your plan still holds.
Karin Risi: In fact, you should take a look and see if your plan still holds, yes.
Amy Chain: Very good. We actually have a live question coming in. Joe, I'm going to send this one your way, and in fact, I've seen a question like this come up several times before today. This one comes in from Steven, and Steven says, "Can you address the risks related to the possible sequestration?"
Joe Davis: Sequestration, okay, so for the audience and some that may not be familiar with that term, that is the potential for effectively $85 billion in the withdrawal of government spending from the economy around March 1. That was, in part, due to the deal the government—the government deficit deal in 2011, the budget deal. It was intended in part, even up through the fiscal cliff, to put that in place to actually incentivize members of Congress to pursue greater fiscal deficit-reduction plans. We haven't seen—well, we've seen some progress but clearly not in my mind more meaningful long-term progress. So I guess the related question to that is should we pass sequestration, have no budget deficit deal, or compromise? And that hits the economy, that would clearly be a drag in the near term. In my mind and by our calculations, it's not as severe as what could have been if we went fully over the fiscal cliff at the end of December of last year.
It would, I think though, still cause—it would be likely associated in my mind with market volatility. We would see a month or two where economic statistics, in part because of potential government layoffs or furloughs, hit the economy. So it would be somewhat disruptive.
That said, if sequestration, if we pass through that and it sticks for ten years, that would provide, by the Congressional budget office estimates, around $1.2 trillion in debt reduction. So that is a meaningful step. It's not a sufficient step in my mind, but it's a meaningful step in terms of broader, longer-term fiscal sustainability which is clearly one of the seminal questions that faces all of us as citizens and as investors over the next decade.
Amy Chain: Joe, I'm going to send another question your way but I'm changing gears a little bit. This one comes from Jennifer in Princeton Junction, New Jersey. Jennifer asks, "Could you explain the phenomenon of a cyclical bull market in a secular bear market?" Say that five times fast.
Joe Davis: I'm not even going to try. Well, again, a bear market is generally associated with a 10% or more decline in the equity market and in the stock market from peak to bottom. Secular just—again, the difference between secular and cyclical is just the time horizon with which that can occur. You only know about a secular bear market or a cyclical bull market, for that matter, after the fact. Some investors point to periods in the 1970s and '80s where if you just looked at the S&P 500, the index level, it was generally the same level, say 10 years later versus, what, 10 years previous.
Now within that ten-year time period, there was ups and downs, and you could have run-ups of 20% or more, and you see that throughout periods of time. And it's not surprising since the stock market, even though on average it's returned 9% or 10% over the past 80, 90 years, the standard deviation over any one year can be plus or minus 20%, so it's huge, and so you would expect this sort of volatility associated with it, so that's the concept.
Clearly whether or not we're in a secular bear market, we were in, in many ways over 10 years, or the past 10 years, the equity market is up around 8% or 9%, but if you looked from, what, 2000 to 2009, 2010, that was what some called the lost decade. So that was what you could, I suppose, characterize as a lost decade, perhaps even a secular bear market. But what we've seen over the past three years, I think more likely than not, it could not be characterized as a secular bear market. It's possible, but I think it's unlikely based upon some of the research we've done and just looking where initial conditions are today.
Amy Chain: So maybe someday we'll look back and say it was or it wasn't, but today—
Joe Davis: Again, I mean, we won't be able to say anything more definitively than that.
Amy Chain: Steve from Sacramento has a question, Karin, that I'd like to send your way. Steve asks, "Give me some guidelines that I can use to decide when to get in and out of the U.S.A. and foreign stock markets and bonds. I don't think we have an environment where we invest for the long term anymore. If you disagree with me, just tell me that," he says. So, Steve, thanks for the great question. I think Karin has a—
Karin Risi: Thanks, Steve. So I will—I'll keep it short because this amounts to another market- timing question. I do disagree on two counts. One, I don't think you should try and get in and out of international versus domestic equities any more than I think you should try and get in and out of sort of the top-line asset classes, stocks, bonds, cash. Two, I do think investing for the long term still makes the most sense. Let me just make two quick points, though. The first is investing for the long term, it's not—that does not amount to a "set it and forget it" strategy. I think "stay the course," "invest for the long term"—we're fond of those phrases at Vanguard, but that does not mean by any stretch that you don't have work to do as an investor. You have to know what you own. You have to commit to periodically reviewing it based on your life situation, being pretty disciplined about rebalancing to that asset allocation. If, in fact, it's the right allocation, you need to be disciplined about sticking to it. You also should be thinking about things like the underpinnings—cost and tax efficiency—that underlies the whole process. So frankly, many investors don't do any of those things, but they're still looking, "What's the guideline to get in and out of a particular asset class?" So I would say make sure that you're doing the fundamentals, and there is work to do there as an investor.
The second point I'd make is just quickly on domestic versus international equities. When you think about the difficulty—and Joe's team has plenty of data that proves this out—when you think about the difficulty of timing stocks, bonds, and cash, when you go one level down into what we would call a sub-asset allocation, domestic versus international stocks, think about the new elements that you introduce that you also need to know about. Think about geopolitical risk, currency risk, what's happening across the different countries' economies. There are a lot of things that on top of stocks, bonds, and cash that you may also not be privy to when you think about domestic versus international. So I would say it's even that much harder when you try and do it at the sub-asset level. I don't know if you agree.
Joe Davis: No, I couldn't say it any better, clearly. The other thing, I mean, just look back at the past two or three years. What I don't think sometimes gets enough attention—it's frustrating for me how much I believe, sincerely believe, in Vanguard's investment principles, just from where I sit from the investment strategy groups and following the economy and involving the portfolio management process—the past three years, some of the three biggest themes were there were strong conviction by many portfolio managers, many investors around the world, those some that may be on TV that, A, inflation was going to take off, I mean, rampant inflation.
Another one was convinced last year that European equities, although they already sold off, were going to be sold off much more and to get out, and you saw some of that in cash flows. And third, the strong conviction that interest rates were going to rise, and rise markedly, given the levels of debt.
Now I'm not here to say well, we were smarter than others. We were just saying listen, there could be other factors that are at work that may not lead to that conclusion. And I think for many investors looking beyond—my point in bringing that up is looking beyond and to have listened to what Karin is suggesting and having lived that, I think everyone should be patted on the back, quite frankly, because there's some very smart individuals that are saying react in a very strong way. They would appear to have a lot of conviction, and so I think it's important sometimes just to review, "Had I listened to that, had I listened to that, had I listened to that" and to take a full closure, and that's where I think you come back to the very principles that Karin is mentioning.
Amy Chain: So I hear us saying don't make a knee-jerk reaction. Yet, we have a question that comes in from Elaine. Karin, I'm going to start this one with you. Elaine, who says, "I sold all of my stocks and funds on the day that the market hit bottom. I've held a total cash position since. How do I get back into the market now, slowly, with dollar-cost averaging?"
Karin Risi: Okay, so what I would say to Elaine is first, she's not alone, right? She may be sitting there on the sidelines with a lot of cash thinking gosh, I wish I hadn't done that. So this amounts, too, to market-timing but for a different reason, right? I alluded to it earlier. This investor is not—I presume was not trying to game anything. They probably were really nervous when things started to fall apart in the equity markets a few years ago. They went completely to cash. She's not alone. I would say—I'd encourage her and others in the same boat—take it as an opportunity. You're sitting with a pile of cash. Sit down and figure out what are you investing for. You need to get back into the market. She's already resolved to do that; that's good. Make sure she does it in a purposeful way. What should your stock and bond and cash allocation be? What are your current goals? Make sure your allocation matches your current time horizon and your current financial goals. So she's got an opportunity. She perhaps made a mistake, along with many others, and now she has an opportunity.
The question around dollar-cost averaging, I think it's commonly held that dollar-cost averaging is a way to get back into the market, and it is, though we've done research at Vanguard that would actually say what I'll refer to as lump-sum investing might be the better way to go and that's really for a simple reason and that's stocks and bonds—generally speaking, the relationship between stocks and bonds versus cash is that you get a higher return from those two asset classes than cash. She's sitting in cash. The sooner she gets to her desired target allocation, the better over the long term.
Now, that is the technically correct answer, right, to do it in the lump sum. And in fact, for the clients for whom we advise their assets, that is what we tell them to do. There's another area of study that isn't the focus of this webcast, but it's an interesting one, which is behavioral finance, and we spend a lot of time at Vanguard looking at that, as well. For some clients, and perhaps for Elaine, the notion of doing everything in a lump sum—she might be nervous about that, and some clients are, and if it makes you feel more comfortable to dollar-cost average in over, say, a period of 12 months, that's fine. The point is, get back in to the desired allocation. Don't take forever to do it. If you can do it in a lump sum, that's probably better. If you can do it within a 12-month period, that's fine. The only thing I would caution Elaine and any other investor to think about is, do you really have the discipline to do it? Every month, will you put that measured amount in to get you towards your allocation? Here's where an advisor can help to act as sort of a coach there.
As long as she thinks she will have the diligence to do it every month and not worry about what the market's doing on the day she's ready to make that transaction, that's fine, but lump sum may be the better approach.
Amy Chain: That's great. Elaine, thank you for the honest question, and we believe in you; you can do it. So we actually had a live question that just came in, so let's go to this question from Gary from Connecticut. Gary asks, "I hear what you're saying about investing for the long term, but what do I do to minimize portfolio devaluation if the economic bubble bursts and the equity markets tank?" Joe, can you tackle this one? Karin?
Joe Davis: Again, I mean, I think the one thing the crisis clearly from 2007, 2008 is a historic reminder for everyone is that despite anyone's experience or background, that a reminder that anything is possible. So I think for anyone, myself included, to say, "Ah, don't worry about that. The risks are minimized," I think a heavy dose of humility is always respectfully desired in investing, in life, and just approaching life in general. So even though I don't see that as a high probability of that occurring, it's not something to be dismissed out of hand. I think you would have to—I would suggest going back to the sort of process that Karin is walking through. Say okay, if I have that, if I have that concern, maybe that suggests a more conservative allocation. I don't know what your thoughts to how—if that question was posed to you and your team.
Karin Risi: No, I agree.
Amy Chain: And I think it probably goes back to a lot of the fundamental questions we say to ask yourself when you're putting together a plan. If your plan doesn't let you sleep at night, it may not be the right plan, so make sure—
Joe Davis: Yeah, and I think the other thing just be I—the economy. I mean, we put some—I had the honor of speaking last year. It was a broadly—the theme was America's economic future—and so there's some serious challenges we continue to face. Our debt levels, our fiscal debt levels, are still my primary concern, but that said, I look at the private sector—consumers, businesses, households—and there has been, after a great deal of pain and dislocation, there has been some significant healing in the economy. We're not out of the woods yet, but I look at everything from housing to business profitability to some of the pay-down in consumer debt levels. Again, high unemployment levels, still a ways to go on the debt situation, but we have seen credit expanding, lending expanding, investment and profit margins remain high. So we're seeing this globally, too. So I—there is—it's not all doom and gloom, as I see it, in terms of the balance. I see some sectors of the economy continuing to heal, some more impressively than others. That said, there's still work to do, particularly on the government front.
Amy Chain: That's great. Joe, I'm going to stick with you. This one is more about interest rates. So Lawrence from Teaneck, New Jersey asks, "Should I reduce my long-term allocation to long- duration fixed income in this rising rate environment?"
Joe Davis: Well I guess the key question there is whether or not this is a rising-rate environment. Historically, long-term bonds have offered a higher coupon, or higher interest rate, than lower-term bonds. They're also why they have higher interest rate risk, or volatility, associated with them. So again, it's going to go back to Karin's framework in terms of, "Is that portfolio risk level and part of the broader asset allocation strategy appropriate for me?" Again, our broader message on fixed income is having reasonable return expectations regardless of the portfolio. So even long-term interest rates have come down markedly and so reasonable return expectation will be markedly lower than it was in the past. I think that said, I think we do have to separate—and I blogged about this several months ago—is just because interest rates are low does not guarantee by any means that rates are going to rise. More likely than not, yes, but if even the recent history of Japan has shown, with debt levels that are twice as high as ours, that they still have the same interest rate structure today as they did 20 years ago.
Now again, so in many ways, I'm hoping that interest rates gradually rise over time, which is what the bond market is expecting because if they had not happened, we'd have a different economic outcome over the next five or ten years. But if you even look at the '70s and '80s, what a diversified bond portfolio would have done during a rapidly rising interest rate environment was not necessarily pleasant. I'm not going to sugarcoat it. But $1 invested in a broad bond fund in, say, 1973 went to more than $2 by 1983. That's when rates more than doubled, but it's important to stay invested and reinvesting that principal if that is consistent with the risk tolerance.
Karin Risi: Yeah, the only think I would comment on is, this investor's question is similar to that of many that we get, and Joe, you're right; we don't know for a fact that we're in a rising rate environment, but certainly that is the expectation and it actually—I'd point out we've been hearing that from clients for several years. They have been expecting this for a while and it hasn't come to fruition yet. So I agree and understand the investor's sentiment. It's one of the reasons why when we construct portfolios over the long term, we look for—you mentioned a broad bond fund, Joe—we often use a broadly diversified bond fund that has exposure to all aspects of the yield curve, so short-, intermediate-, and long-term duration bonds.
On average, we look for an intermediate-term duration. So we don't know whether this investor has short- and intermediate-terms bonds as well as his long exposure, but just a point to make that we look for an intermediate-term duration, in general.
Amy Chain: Now speaking of bond funds, I'm going to stay on that topic for a second. We have a question from Jim in North Carolina, who asks, "Does Vanguard offer an international bond fund and would it be a good place to reallocate funds out of Vanguard's Total Bond [Market Index] Fund?"
Karin Risi: So the answer is very soon. We're excited. Earlier this month, we announced—had a press release that we will have the Total International Bond Index Fund to complement our other "total portfolios," as we call them. So we will have the Total International Bond [Index] Fund, and we do think that that's an opportunity to integrate that into a well-constructed, broadly diversified portfolio. That fund—if you think about our Target Retirement Funds—that fund will be integrated into those portfolios at a 20% allocation to the fixed income portion of the respective target-date fund, so that's an allocation to think about as a starting point. It might be different for every investor, but if this investor is asking, how would I integrate a fund like that into our portfolio, that's what we'll be talking about with clients and probably at 20% of the fixed income allocation is at least a good starting point. Now I will say that 20%—and that's based, again, on Joe's team's research—assumes that the fund—the currency risk is hedged, so that's an important point.
Amy Chain: That's a very important point.
Karin Risi: So across all of the international bond funds available, ours will be hedged, and we think that's an important aspect. We would not go with a 20% allocation if it were unhedged, and some funds in the industry are not. Is that fair?
Joe Davis: No, I think that's great way. I mean, that's—I'm proud of the team. They did some great work, Chris Philips and others, and it's—that's an important point. That's going to be—it's very distinct—in some ways, very much distinctive in the marketplace with hedging the currency risk because just the research has shown that if you do not hedge the currency risk, which means try to take that off the table, you have a bond portfolio that does not look like a bond portfolio anymore. It looks more equity-like in terms of its ups and downs any day, week, month, or year. So that is important because what you're trying to do is get exposure to different yield curves, so to speak, across the world. In the same way that we would say having international non-U.S. equity exposure will, at the margin, modify some of the wiggles across the global economy. That same logic is at place with the international bond funds. I'm very excited about the development, as well.
Amy Chain: So I think that's an important point to reiterate. So we believe in an international allocation to bonds, but we believe that it should be a hedged allocation. So look carefully before you invest. Good.
Let's stick with asset allocation and fund-type questions. I have a question from Nisha in New Mexico who asks what percentage to invest in stock and what percentage in "other" for someone who has 15 or more years before retirement?
Karin Risi: Okay, so I'll take that one. We don't know a lot about Nisha. What—I'll make a guess, and it's only an assumption—what she's told us is that she has 15 years to retirement, so let's pretend that she might be around 50, right? Everybody retires at different ages, etc., but again, I just mentioned our Target Retirement Funds. The glide path that we use that underlies all of those funds, or that series of funds, is at least another good jumping-off point for someone like Nisha, or any other investor, to consider. If a person were 50 years old and if they were invested in one of our Target Retirement Funds, they would have, on our glide path—and that's sort of the mix of stocks, bonds, and cash—it "glides" over time in the sense that you start out with a greater allocation to equities and that gradually decreases to a greater allocation in bonds.
Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the Fund name refers to the approximate year (the target date) when an investor in the Fund would retire and leave the work force. The Fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date. Although Target Retirement Funds can simplify investing, they are subject to the risks associated with the underlying funds.
If you're, let's say, 50 years old with about 15 years to retirement, you would be 70% in stocks and 30% in bonds. So the pointed answer to her question, using our glide path as just a framework, 70% stocks, 30% bonds. It's important to remember that a target retirement fund, it only takes into account time frame, time horizon to retirement. It doesn't necessarily take into account the fact that every 50-year-old, in this instance, Nisha or anyone else, they don't all have the same risk tolerance, so there is a presumed risk tolerance there. You have to really think about what a fund like that—the benefits of it—and then what might be different about your own unique situation, so you have to make a conscious choice there.
The other thing that many Flagship clients or clients in our Asset Management Services group who might be listening, they might have accumulated wealth such that they have different goals. They may—just as an example—they may want to do multigenerational wealth transfer. If they do, they may want to set aside some portion of money that would have a much more aggressive allocation than their 50- or 60- or 70-year-old age might imply because they might be thinking about that these assets are carved off for someone much younger, frankly. So you have to think about what's taken into account when you're considering your asset allocation.
Amy Chain: That's interesting. Phil from Georgia, actually wrote in a question saying about the old rule of thumb that the percentage of bonds should hold equal to your age. So maybe we could talk a little bit about, on a whole, what do we think about that old adage?
Karin Risi: Yeah, again, it's not a bad jumping-off point, and just to be clear, that rule of thumb is—it's been out there for a while—and it's essentially "own your age in bonds" such that, as an example, if you're 80 years old, you might have an 80% allocation to bonds, and that doesn't, on the face of it, sound like a terrible starting point. You have to remember it may be more conservative in this day and age when longevity risk—people are living to 100. Again, if I go back to that glide path, we plan, and if I think about wealth planning at Vanguard, we plan for investors to live to 100. I don't know that we did that 20 years ago, so there's something called shortfall risk, and an investor has to be thinking about whether they have enough exposure to equities to ensure that they keep pace with inflation and that they outlive their assets, right? Shortfall risk is the opposite of that. You don't keep pace with inflation and you may not outlive your assets. So again, as a starting point, the glide path for target-date funds as an example, we would have investors from about the age of 75 onward, 30% invested in equities, and we would maintain that as a static allocation, so we would not bring that down over time.
If you think about that compared to the "own your age in bonds," an 80-year-old invested in one of our Target Retirement Funds would be 30% in stocks, 70% in bonds. The rule of thumb would imply a more conservative 80% in bonds. So nothing is right or wrong. It's dependent on the investor, their risk tolerance, their time horizon, frankly, the amount of wealth in their portfolio. They can perhaps afford to be more aggressive or maybe preservation of principal is really what they're focused on. So those things will alter that rule of thumb. Hopefully that's helpful.
Amy Chain: It's the best I've heard yet, best take on that old adage. So Joe, let's send a question to you. This one comes from John from Texas. The question is, "Over a 10-year time frame, what factors have the biggest impact on stock returns?"
Joe Davis: I think we mentioned before, and we may've had a graphic prior, it's the valuations, so P/E ratios in particular, and there's various metrics. We have two on the far left of the screen that the viewers may be seeing, one where the earnings, trailing corporate earnings, are smoothed out to get around volatility, so forth. It's what a professor at Yale, Bob Shiller, first—well, he was not the first one, but he made it more popular—called the Shiller cyclically adjusted P/E ratio. A lot in the advisor community tend to really focus on only that metric, and why I bring that up is because by that metric, the equity market would suggest it's a little bit overvalued over the next ten years, but as you can see from some of our research, the predictability or the association with future returns, of even the P/E, just using earnings over the past year, which tends to be more volatile because earnings, if you recall, they go up during a boom and fall down in recession. So you want to try to get out some of that volatility because no one knows perfectly what to do. What our general research found in that broader paper is that, listen, there's no one that's clearly superior—has been superior historically with future returns. I think it's important to look at valuations collectively as a whole and when you throw them all together today, you're close to historical-like in terms of valuations.
That not only is us, in the United States versus our long history, it is also, generally speaking, the case of valuations across different regions of the world, as well, because I know there was some questions submitted around parts of the world. So again, it's safe to say that's why on a global equity portfolio basis, there's decent odds that stocks will outperform bonds over the next five or ten years, which I think is good. And it's really—you have to look beyond, I think, the economic environment because on the mainstream, the consensus is U.S. economy's going to plug along around 2%. It's half of our historical growth rate. Emerging markets are going to grow faster, but that's been the theme of our research, as well, trying to minimize—and this is an economist speaking, right—trying to minimize more of the attention paid on economic statistics with those that pay to more long-term investment principles, and it's not easy because you tend to put the strong focus on daily and weekly reports on that ladder.
Amy Chain: Very good. Joe, another one for you and this one comes from John from Bryn Mawr. So John, you're just around the corner from us today. The question is, "With the overhanging, rapidly increasing national debt, why do stocks keep going up? Does there have to be a day of reckoning, and will that crash the market or won't it?"
Joe Davis: Wow.
Karin Risi: Can you answer that?
Joe Davis: Can you answer that? Very definitively. It's funny, we actually looked at the research, I mean, on that chart before. We looked at debt levels—debt as a percentage of the GDP—which is a common metrics, and right now the United States, the debt held by the public, we're around 73% of GDP. I mean, just for historic, we've been at over 100% during World War II, but nevertheless, we could be projected to go, if current fiscal policies are in place, well over 100% 20 years from now. But ironically there is an association with high debt levels, with future stock returns in the U.S. It's just it's the exact opposite of what investors think.
Now I don't believe that'll hold going forward, but historically higher debt levels have actually been associated with higher future stock returns. Now again, I think that's just an artifact of the data. I wouldn't believe that to hold, but why that occurs throughout history—you know, in our—why that occurred in our history is we had to hide that debt run-up in the 1940s during World War II. That came down in part through financial repression, which is effectively low interest rates net of inflation, and our strong growth out of the war, and so the equity market took off. So that's where that association's coming from.
I think it's also an important point is the acid test of what we really think is endearing from a relationship, what's not, so I don't believe that'll be hold going forward, but that said, clearly we have not found a strong negative correlation, and we found that across countries, as well. And why that matters is it's not just the level of debt; it's the sustainability of the debt as well as what is the government or the economy doing to correct those debt levels? So we've had examples. This is in Europe at play right now. I don't know if it'll sustain, but some countries such as Spain, their debt level has been high, or in Greece, had been rising, right? But yet their deficit's coming down through the fiscal austerity. And the European equity market—of all the regions—the European equity market was the strongest performer last year even though it was the worst developed market economy.
So I think again and again, this underscores the fact that valuations can, at the margin, can be a tailwind. Debt is going to be a drag but in and of itself, I'm not convinced that just because debt levels may be projected to be high that that is a convincing or very pernicious environment for stocks. I think a lot of it will be dependent upon what sort of policies we may enact over the next ten years. I think that said, the market may test us. The equity market, bond market may test policymakers to nudge them along to make greater policy change.
Amy Chain: That's great, thank you. So we're going to stay local with another neighbor's question. Art from Lansdale, Pennsylvania, another city nearby, asks Karin. His question is, "How will U.S. versus international stocks perform?" I think I know where you're going to go with that one, but the second part of the question is, "What's a good split between the two for a portfolio?"
Karin Risi: Okay, so you're right. The—I can't tell Art or anyone else how the two classes will perform, U.S. versus international, but I certainly can speak to how we think about constructing well-diversified portfolios. First of all, we do think you should have exposure to both U.S. and international equities. In thinking about a good starting point, we think 30% exposure to international equities is a good starting point, but really there's a range there. Anywhere between 20% and 40% is very reasonable, and where you are along that range, Amy, really depends on what your risk tolerance is, how comfortable you are with that international exposure. If clients ask us, we start at 30% and then we get to know the client and understand where they might operate within that range. But we have found through research that anything more than a 40% exposure to international equities, you start to get diminishing returns, so the diversification benefit is really what you're after in adding international equities to the portfolio, and that diversification benefit starts to trail off after 40%.
Amy Chain: Very interesting, thank you. Joe, let's send another one to you. This comes from Thomas in Buffalo. Thomas, thanks for your question. "Do you think that the slow decline in unemployment will affect the markets as the year progresses?"
Joe Davis: Well, I think that if all's equal, the unemployment rate, which is slightly less than 8%, again, if it proceeds according to what it's expected to, it shouldn't, by definition, at least by financial market theory, have any relevance. Unemployment rate is actually a trailing indicator of the economy, and the markets, equity markets, are forward-looking. So if you're already pricing in some sort of trajectory, actually our best estimate is that the unemployment rate continues to gradually come down, and that's actually what the Federal Reserve's expectation is. It's consensus expectation, which means most economists, and I think that's a fair characterization. So what we're really—to get to the question—what could influence the markets more than expected would be a market deviation from that gradual decline, say from the high 7%s to say 7½% by the end of this year because that's where most expect.
If it would come down crashing down because the economy and job growth is markedly higher than expected, then that could be associated with greater market volatility, and I'm not necessarily saying higher equity market returns because that could be the market reacting to, well, maybe the Federal Reserve will start tightening rates.
So again, also at the same time, it's ironic. You could have a worse than expected progress on the unemployment rate that you could—like we've seen the past several years—you could have the equity market up for other factors that we cannot necessarily quantify. So it's only going to be that deviation from expectation that could really move the markets, in my mind, but it's not even clear that if we knew exactly if it was going to be higher than expected or lower than expected, that I wouldn't personally make a change in my portfolio based upon, even if I knew for certainty it's going to be 7% or 8%, the unemployment rate at the end of the year, because I'm still not convinced that that would tell me how the equity market may respond because there's so many other factors involved in that deduction.
Amy Chain: Very interesting. Karin, let's send one to you. This comes from David. David asks, "Fama-French's analysis says that small-cap value stocks perform best over the long term. However growth stocks outperformed value stocks in the U.S. over the last 15 years. How seriously should one take the distinction between value stocks and growth stocks?"
Karin Risi: So I think this is a good—I'm glad this question was asked, not because I have a particular opinion on growth versus value but because I think it makes an interesting point, right? Fama-French is widely held, well-respected research, and sometimes the markets can be humbling. This investor's right. You expect small-cap value to—their relationship to hold over long periods of time, but over the last 15 years, which many investors would view as long term, that's not what happened. Growth outperformed value, and Joe mentioned humility before, and we've been humbled many times by the markets in different aspects; this is just one, but it makes the point, again, for holding a broadly diversified portfolio. So this is why you should have both.
You should hold growth and value stocks. We would say you should hold them in a market- proportion weight because you don't want to make any unintended sector bets, frankly. So growth and value is kind of a style—investing style we call it—and by tilting one way or the other toward growth or value, you can make an unintended sector bet.
For instance, if you're heavily tilted toward value, maybe because of this research or any other reason, are you intending to be overweighted in financials? That's sort of a traditional value sector. Alternately, if you're tilted toward growth, the growth style of investing, outside of the market proportion, are you making a bet on technology? Are you intending to because if you're in a broadly diversified index, you already own all of those sectors, so any tilt that you make is a bet, and it may not be a disruptive bet if it's a small tilt. The degree of the tilt is what's at stake, but we would say hold it in a roughly 50/50 proportion, which would be the market proportion.
Amy Chain: It's a bet but know that you're making it, essentially.
Karin Risi: Yeah, be conscious of that.
Joe Davis: Yeah, exactly, and what sort of information may that investor have that they believe that the market has mispriced or underappreciated, and are they willing to hold that strategy for that long period of time, which as Karin says, the question as they've duly noted can be more than 15 years.
Amy Chain: That's great. All right, let's look for one for Joe here. We've got Don from Lake Elmo, Minnesota asking, "If the sequester is implemented, how large of an effect on the markets over the short term or long term can we expect if Congress chooses not to fix the sequester?"
Joe Davis: Well, I mean, I would—again, I'm expecting at the margin that we actually pass through sequestration, which means it hits, even if we could then see a quick compromise thereafter. In large part, how that plays out could in part depend upon how the market reacts, but again, I think this is an important point to look beyond because I mean, look at the consternation, myself included, with the impending fiscal cliff that was coming, right? And the fact that we went over it for a day and yet, look at when the strongest performing days of the past year was actually January 2, January 3 when the markets opened, right? So I think that's an important point to try to look through that and to know that the headlines with respect to our fiscal situation—I think we just have to be prepared for as investors and as U.S. citizens, that this is unfortunately or fortunately going to be with us for two or three years, and the same way that we mentioned that we had opportunity during a webcast last year that the headlines with respect to Europe, they may happen—they may go from Page 1 to Page 2 or to Page 10, but I think they're going to be in the dialogue for the foreseeable future. I think we have to be prepared for that, and I think if you do that, that can at least help at the margin some of the emotional and the sort of environment we have to contend with because I think if we're a little bit better prepared, we can help steel the nerves, so to speak, in this investing environment.
Amy Chain: That's great. So I can see that we're getting close on time. We probably have enough time for one or two more questions, so I'm going to throw one out. I'm going to throw it to you, Karin, but Joe, feel free to jump in. This one comes from Joel from New Jersey. Joel asks, "In a buy-and-hold strategy, how much of an overall portfolio loss should an investor accept before deciding that this time it's different and that the recovery phase may take longer than the investor's time frame?"
Karin Risi: Again, this is a pretty common sentiment, right? I will say internally at Vanguard, every time we hear "this time it's different," it causes us to pause, right, because we actually think over long periods of time, it's not that different, but nonetheless, I think Joel's point is really fair and many clients express something very similar, and there's no—certainly when we work with clients on an ongoing basis, there's no absolute value of a portfolio. There's no percentage or dollar value that I would say once you lose 5%, you should do something different. We don't construct portfolios like that and we don't think about it that way.
I would say it's an opportunity to ask what's your time horizon, and if it's something less than, say, two years, really you should not be in the equity markets. You should be invested in short- term instruments of some kind—CDs, cash, money markets, etc. And if you have decades to invest, well, then you should be in the equity market and you should be willing to ride out that exposure. What I'm going to guess from the phrasing of Joel's question—he mentioned something about "might not have time for the recovery, etc." I'll just make a guess that he might be somewhere in the middle, and the easy answer is to say hey, if it's short term, it should be in cash and if it's long term, you should be in equities and not worry about it because you have time to recover.
For many investors, I'm thinking kind of in the pre-retiree stage who might have the intent to have a longer-term time horizon but in reality, they might be saying look, I want to work ten more years, but maybe it's going to be five. I really don't know. It's somewhere in that range, and I'm a little nervous about having the equity exposure, but they've got to balance the shortfall risk that I mentioned earlier. So they're in a tough spot. When you're in that intermediate range, it's hard to say hey, don't worry about it. You've got plenty of time, be in the stock market, or no, you should put this all in cash. It's a balancing act between the shortfall risk, as I mentioned—you don't want to have too much in cash—and balancing that with the downside risk of being overexposed to equities when you may need that money in five or six years.
So it's those clients with whom we work to really get that balancing act. Amy, you mentioned something earlier around your ability to sleep at night, and we use that phrase a lot internally, as well, when we talk to clients because if it makes you feel better, if it's the point at which you can sleep easy to carve out, say, two years' worth of cash—generally we might say 6 to12 months of cash as an emergency reserve; that's kind of another rule of thumb. People are tending more toward 12 months, but for some clients that we work with, if having two years sort of carved off and safe makes them feel able to sleep at night and then they can go about the rest of the allocation for the portfolio, that's fine. It's not—there's no right or wrong answer and there's certainly no trigger point at which I'd say you have to revamp the entire portfolio because you've lost "X."
If somebody's feeling that way, I would say it's an opportunity to revisit your risk tolerance and your time horizon. If your time horizon is more uncertain or more intermediate in nature, yes, maybe you should adjust a little bit, pull back a little bit on equities, maybe boost your cash holdings, but it's very individual to each investor, and again, it gets back to how much wealth has been accumulated? Can you—do you have the ability to weather that risk in the stock market? I hope that makes sense.
Amy Chain: It sure does, thank you. I think we might have time for one more short question, but these are all great questions. I don't know how quickly we're going to be able to get to them. Joe, here's one. Ready? This one comes from Massachusetts: "Do you think we can still count on 8% return on a long-term basis?"
Joe Davis: No, I don't think we should count on things like that. I think it goes back to our previous conversation. I mean, 8% return, I presume that's a nominal return which means before inflation, has always been a generally tough exercise on any shorter horizon, just given the volatility in the markets. So I know it can help simplify thinking, but I think generally what has been a good approach has been, let's be, if anything, conservative on our expectations. We're clearly trying to do that right, as a firm, as investors on the bonds side, and even if we have close to historical-like potential for equities, still, let's be, if anything, a little bit conservative because I think that gives a better chance to be pleasantly surprised on the upside and also may not lead one to be overly aggressive. So I think if anything, let's be conservative and realize there's a range of returns and not just one number.
Amy Chain: That's great, thank you. So it looks like we're just about out of time, but I want to thank you all for joining us today. Joe and Karin, thanks for being here, as well. Any final thoughts to share before we sign off?
Karin Risi: No, I think just we've hit on it a lot. We got a lot of question about market-timing, so I feel compelled to just say take a step back, look at your allocation, think about a plan, be more concerned with the factors that you can control in thinking about your portfolio. Be less concerned with trying to predict the outperforming fund, sector, asset class.
Joe Davis: And the only other thing I would say is actually don't feel bad to actually recognize that one has—that one is uncertain and has uncertainty because I think actually that takes greater courage than just saying with complete conviction that one knows exactly what's going to happen. I think actually the opposite can help steer one to better long-term investment success.
Amy Chain: That's great. Thanks, everyone, for joining us. You'll receive an e-mail from us in just a couple of weeks with a replay of today's webcast and also a transcript. If we could just ask you for a couple more moments of your time, we'd love if you could fill out a survey for us. It should appear when you close your browser. If it doesn't, check your popup blocker. It might be blocking the survey. So from all of us here at Vanguard, we want to say thank you and have a great day.
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