One of the main tenets of investing is that the higher the price you pay for an asset, the lower your long-term returns are likely to be. Valuations move in cycles around an average, so the pricier an asset is when you buy, the longer it will take to make money. Today, thanks to central banks showering markets with liquidity, pretty much everything is expensive. Central banks have postponed the return of valuations to bargain-basement levels in recent years. By propelling stock and bond prices to artificially high levels, they have borrowed returns from the future.
Given this backdrop, many investors and pension planners remain far too optimistic, as Robin Wigglesworth points out in the Financial Times. Asset management group Research Affiliates says most are pencilling in a real annualised return of 5% in future, even though there is only a 0.2% chance of the traditional balanced US portfolio – 60% stocks and 40% bonds – reaching that target. Bonds have been rising since the early 1980s, while Wall Street has rarely been this expensive, judging by the cyclically adjusted price-earnings ratio of 26 – miles above the long-term average of 16.
Large US stocks are so expensive that annual returns over the next seven years will be –3.7%, reckons asset managers GMO. But stock investors should not despair entirely; GMO thinks emerging-market stocks are cheap enough to produce annual returns of 3.7% a year, while Japanese and European stocks still boast reasonable valuations and yields. We continue to suggest that investors start searching there.