Gordon Pape: Projecting the best investment returns over the next seven years

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Think about this very carefully. If you had to decide now where to invest your money to earn the best return with the lowest risk over the next seven years, where would it be?

Many people would say the U.S. stock market. They would be wrong, according to a new analytical tool published this month by the asset allocation team of Mackenzie Financial.

You are likely to earn a much better return by investing in the stock markets of Britain, Canada and Australia than by focusing on Wall Street. U.S. stocks are overpriced right now, as are those of Japan. By contrast, Europe, Canada and Australia are undervalued.

As for bonds, don't invest too heavily there. Government bonds with a 10-year maturity are likely to generate a negative return over the next seven years.

These are the conclusions of a white paper prepared by Todd Mattina, Mackenzie's chief economist and strategist, and Alain Bergeron, a senior vice-president and head of the company's asset allocation team.

They believe that asset valuations are a key driver of total returns over longer time horizons. "Historically, low asset prices relative to the fundamentals have reliably predicted high long-run returns," they write.

P/E 'simplistic'

One of the main points they make is that using traditional value measures such as the price-to-earnings ratio does not provide a true reflection of asset values. They describe that approach as "simplistic."

"[P/E ratios] can signal attractive value opportunities when the fundamentals suggest otherwise," the report says. "For example, a high P/E ratio may reflect low expected interest rates, supporting higher sustainable prices."

Conversely, a sudden drop in share prices could lead to a rapid drop in the P/E ratio, suggesting an attractive value opportunity. "For example, as the global financial crisis began to unfold in September, 2008, share prices dropped sharply in anticipation of a financial crisis and broader economic slowdown. However, the P/E ratio based on trailing earnings in the last 12 months suggested incredibly cheap share valuations."

Emulate Buffett

The authors suggest investors need to look at the present value of future cash flows. This means emulating the success of investors such as Warren Buffett by finding shares in companies that are cheap relative to longer-term fundamentals.

To help investors do this, the authors have developed a model called multiasset class intrinsic valuation (MACIV for short) for use within the Mackenzie organization. For the mathematicians out there, this is described as "a multi-stage discounted cash flow model that estimates fair value based on the fundamental drivers of expected discount rates and expected cash flows. It provides a systematic and macro-consistent approach to measure value for any asset generating cash flows over time."

If you don't follow all that, the important point is that the authors believe that over a seven-year cycle asset prices converge to their estimated fair value. So an asset that is underpriced now will rise more quickly than one that is overvalued.

The Mackenzie executives base their projections on certain assumptions: "We expect a slowdown in trend economic growth in most countries as population aging slows work force growth, capital accumulation slows in sympathy with lower employment growth (keeping the ratio of capital to workers in balance), and productivity remains below the post-war historical average."

Canada should do well

Based on this, they forecast that the U.S. and Japanese stock markets will each return an average of 3.1 per cent annually over the next seven years. At the other end of the scale are Canada at 8 per cent, Australia (9.9 per cent) and Britain (11.2 per cent). Excluding Britain, the projection for Europe over that time is a 6.9-per-cent annual gain. For Asia-Pacific, it is 4.6 per cent.

For government bonds, the outlook is very discouraging. Using the authors' baseline scenario, U.S. 10-year bonds would lose 1.2 per cent annually for the next seven years while Canadian bonds would drop 2.2 per cent a year. Even using more favourable assumptions, bonds still end up in in negative territory at minus 0.4 per cent for the United States and minus 1.4 per cent for Canada.

Mr. Bergeron stresses that this is one of several tools that can be used in determining the asset allocation of a portfolio. "Even though bonds are not projected to do well, no one should go to zero in their bond positions," he said. "You might underweight them but you should still own some."

Similarly, just because U.S. and Japanese stocks are projected to generate a lower return doesn't mean you should not own some. But your asset mix should be adjusted to reflect that.

The authors believe that because the assumptions they use have long time horizons and their projections will not be significantly affected by short-term developments, such as new initiatives out of Washington.

"For example, Donald Trump's policies may have a positive effect on earnings growth but that could be offset by the impact on inflation and the discount rate," Mr. Mattina said. "The anchor on which our projections are based remains quite stable."

The bottom line is that these projections are helpful in deciding on your asset allocation going forward but they should be just one of the considerations that you use in making a final decision.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to buildingwealth.ca.