End of an era for equities and bonds?
The post-Global Financial Crisis period has been remarkably strong and consistent for investors. This includes both the equity market and bond market, regardless of the economic challenges and uncertainty. An investor with a simple 60/40 allocation to the S&P 500® Index and the Bloomberg US Aggregate Bond Index has enjoyed a 12% average return over the past three years and an 11% return over the past 10 years.
Equity markets have been strong on solid earnings growth and expanding valuations, with the largest names in the index providing outsized returns. Bonds have benefitted from falling rates and narrowing credit spreads. But these tailwinds may be changing course. Given current valuations and macro-economic challenges, investors may need to moderate their expectations for forward returns. Double-digit returns in a balanced account are not a guarantee. For example, from 2000 through 2010, the average return for the 60/40 portfolio was just 3%.
Current valuations are also high. The S&P 500 currently trades at 20.6-times forward earnings, well above the average of 16.3-times forward earnings over the past 25 years. Earnings growth between 2021 and 2024 is forecast to average roughly 9%. If that prediction becomes reality and the multiple at the end of that period moderates to 19-times, the average return over the three-year period would be 6%.
For the bond index, the current yield is 1.6% with a duration of 6.8. If interest rates modestly increase over the period, returns would be roughly 1% annualized, bringing the 60/40 portfolio return to roughly 4%. The caveat, which is needed every time we talk about planning for the future, is that equity valuations and interest rates have proven to be extremely difficult to predict.
Facing the prospect for more modest returns for a traditional allocation, investors may want to seek alternatives to boost returns. For example, small-cap, value and international stocks are all trading at less of a premium to their historical averages than large-cap, domestic growth stocks. Also, given that 22% of the S&P 500 is concentrated in the largest five technology companies, active management could provide opportunities. Finally, dividend-focused equities, credit-sensitive bonds, and alternative strategies may provide greater yield than traditional bond allocations.
After the tremendous run for equities and bonds, a period of more modest returns is not unexpected or unhealthy, but it will likely challenge investors that have become accustomed to consistent double-digit returns.
Review relevant client material from Nationwide
This information is general in nature and is not intended to be tax, legal, accounting or other professional advice.
The information provided is based on current laws, which are subject to change at any time, and has not been endorsed by any government agency.
Neither Nationwide nor its representatives give legal or tax advice. Please have your clients consult with their attorney or tax advisor for answers to their specific tax questions.
S&P 500® Index: An unmanaged, market capitalization-weighted index of 500 stocks of leading large-cap U.S. companies in leading industries; gives a broad look at the U.S. equities market and those companies’ stock price performance.
Bloomberg US Aggregate Bond Index: An unmanaged, market value-weighted index of U.S. dollar-denominated, investment-grade, fixed-rate, taxable debt issues, which includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and non-agency).
© 2021 Nationwide