Over the last decade, the market environment has posed a variety of challenges for investors to overcome. This time frame can be divided into two distinct periods of market results: (1) the decline in U.S. equity markets during the financial crisis and Great Recession; (2) the years that followed, which are predominantly characterized by positive annual returns well above historical averages. These periods of drastically different market results should remind investors of the realities associated with market returns and volatilities that can emerge over relatively short spans of time.
At RMB, we realize that investor goals are oftentimes long-term in nature, geared toward planning for retirement or transferring wealth to the next generation. This creates the need to craft portfolios that are resilient and sustainable across a myriad of market and economic conditions. We embrace a long-term investment philosophy and believe in the following tenets of such an approach:
- Analyzing returns over longer time frames promotes objectivity in performance evaluation
- Reviewing market valuation levels provides insight into return expectations
- Incorporating asset allocation into portfolio construction reduces risk over long-term periods
With this in mind, we aim to achieve investment results that help our clients meet their financial goals over time, while navigating the market risks and opportunities that will undoubtedly emerge along the way.
Since 1926, large-cap stocks have produced annualized rolling average returns of 10.1%.1 As a result of the inherent volatility in different market environments and market cycles, an average return can be misleading in that returns seldom produce exactly the average. If we look at the 1-year rolling average return data, the drastic variability of periodic returns calculated over short-term periods is evident (Exhibit 1A).
By comparing to a longer time frame, using the 10-year rolling average figures for example, the levels, trends, and persistency in returns become increasingly clear as the effects from the variability of returns calculated over short-term periods is greatly diminished (Exhibit 1B). Examining returns calculated over longer periods ultimately provides a bigger and clearer picture on which to base expected return potential.
Applying this information to the current market shows that rolling 10-year average returns are below historical averages and suggests the possibility of further positive returns in the near term.
At any given time, a variety of market factors and variables are present that should be taken into consideration for investment decision making. For instance, the effects of monetary policies, including economic growth, employment, and price levels, tend to be reflected in market results. Therefore, examining market statistics, such as valuations, over longer periods can prove beneficial in promoting the long-term growth and sustainability of investment portfolios.
Since 1954, trailing price/earnings (P/E) valuations2 of the S&P 500 have ranged from approximately 7 to 30 with an average of approximately 16.4.3 Most recently, market conditions have shown an above-average price/earnings valuation of 18.3.4 By separating the population of P/E valuations into quartiles, moving from lowest to highest P/E, we observe that periods with lower market valuations tend to outperform higher-valuation periods on a forward basis (Exhibit 2). This should come as little surprise to our common sense consumer mindset, which typically steers us away from buying products that we perceive to be overpriced. By pairing this analysis with market conditions, the conclusions derived from valuation levels can provide an objective basis for estimating future returns and thus can inform long-term investment decisions. Based strictly on the stock market’s current position in the third quartile of P/E levels, we would expect only modest levels of future returns that are below historical averages.
Over short-term periods, returns of different asset classes do not necessarily move in tandem. An example of this is seen by comparing the March 2008 to February 2009 12-month returns of large-cap stocks and intermediate government bonds, where they returned -43.32% and 5.08%, respectively.5 Rather than holding a portfolio defined by the risk-and-return characteristics of a single asset class, asset allocation is employed to capture returns from multiple asset classes with potentially reduced levels of risk.
While asset allocation decisions can position portfolios to navigate and capitalize on different shorter-term market conditions, the long-term benefit is the risk-and-return profile of the overall portfolio. Dating back to 1926, a portfolio constructed from 60% stocks and 40% bonds rebalanced on a monthly basis would produce an annualized rolling average return of 8.6% (Exhibit 3). This level of returns falls slightly below the average stock return of 10.1%, but far exceeds the average return on bonds of 5.2%. In addition to the return characteristics, the asset allocation mix results in significantly less risk as measured by standard deviation, or volatility, of returns. Thus, over the long term, the advantage of asset allocation is seen by substantial returns with lower levels of volatility when compared to the risk-and-return profiles of individual asset classes.
As investors, we should periodically remind ourselves of why we invest. Certainly, every investor would answer this question slightly differently, but it’s likely there would be a common denominator: we are willing to defer spending today in hopes of having more money to spend in the future. For many of our clients, the time frame defined by “future” can range from a few years to decades or generations. Knowing that history tends to repeat itself, especially where economic cycles are concerned, we can expect the future to have a variety of shocks, catalysts, disruptions, and opportunities across capital markets that will result in a wide range of investment results in any given year. We firmly believe that our investment philosophy offers the balance of protection and productivity that will keep our clients on track to meet their long-term goals.
- Morningstar Ibbotson.
- The trailing price-to-earnings ratio is the current stock price divided by operating earnings per share for the last 12 months.
- Standard & Poor’s.
- Standard & Poor’s.
- Morningstar Ibbotson.
The opinions and analyses expressed in this communication are based on RMB Capital Management, LLC’s research and professional experience, and are expressed as of the date of our mailing of this communication. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is it intended to speak to any future time periods. RMB Capital makes no warranty or representation, express or implied, nor does RMB Capital accept any liability, with respect to the information and data set forth herein, and RMB Capital specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice.
The S&P 500 is widely regarded as the best single gauge of the U.S. equity market. It includes 500 leading companies in leading industries of the U.S. economy. The S&P 500 focuses on the large-cap segment of the market and covers approximately 75% of U.S. equities.