"The market had a good run for a while, but now it's right back to where it was."
"I haven't made any money in 10 years."
"Whatever it is, I don't want any more downside."
"I give up."
These statements reflect the sentiment of investors today. The headlines and market gyrations have certainly taken their toll, but long-term investors need to maintain a proper perspective. The disappointing returns of the last 12 months come after a huge recovery in 2009 and 2010. And looking back 10 years, the ingredients were there for a simple balanced portfolio to earn 3 to 5 per cent a year, meaning that, through the power of compounding, $100,000 invested would now be worth between $135,000 and $160,000.
Over that decade, bonds did their job with annualized returns of 6 to 7 per cent, and Canadian stocks, as measured by the S&P/TSX composite index, had about the same return. The drag on balanced portfolios has been foreign stocks, which essentially provided a zero return in Canadian dollar terms.
So where do we find ourselves today, other than frustrated and worried? Is the scenario for investing better or worse than it was in June of 2002?
Well, I can't answer that question definitively, but can absolutely guarantee that the sources of return over the next 10 years will be different than the last 10. I say that because the bond component of our portfolios will do nowhere near 6 to 7 per cent. With yields where they are today, 1 to 3 per cent is a more reasonable expectation. Government bonds used to provide "risk-free return," but now it's "return-free risk."
The outlook for stocks is at least as good as in 2002, and quite possibly better, although clearly there are crosscurrents. The negatives are most obvious. Profit growth is likely to be slower due to a deleveraging economy and margins that are already at high levels. And of course, there's a European crisis to get through.
But in face of all the negatives, is a growing list of positives. Dividends yields are higher, and the steady flow of share buybacks (in lieu of even higher dividends) will serve to boost future profits. The offset to tapped-out governments is more room in the economy for innovative, well-financed companies to expand their role. Out of necessity, we're likely to see more corporate involvement in health care, power generation and other services (Mr. Harper's jails perhaps). And after a period of constant consolidation, a number of sectors have seen two or three dominant players emerge and gain increasing pricing power (Canadian banks aren't the only oligopoly any more).
As for valuation, multiples of 10 years ago still had a lot of air under them after the technology-fuelled runup. Indeed, it has been declining valuations (not lack of profits) that has sucked the juice out of foreign equity returns.
But things look considerably better today. Price to earnings multiples are closer to ground level and more reflective of a high, as opposed to zero, interest rate environment. It's not hard to find growing companies trading at 10 to 12 times earnings with dividend yields above bond yields. At a minimum, there will be a firmer link between profits and stock prices going forward. And when the markets get a little less fearful, we should see higher valuations, which, when added to dividends (2 to 3 per cent) and profit growth (a subpar 3 to 4 per cent), will mean returns in the neighbourhood of 7 to 9 per cent per annum.
I don't think investors have to be too adventurous to achieve this kind of return. A boring portfolio of small, medium and large companies from Canada, the U.S. and beyond will do the job. Catching the more cyclical, lower quality stocks near the bottom would generate supersized returns to be sure, but in the current circumstance, I'm happy to stay focused on companies that have what's needed to drive growth and pay dividends, namely profits.
Will another crisis hit the market next week? Possibly. In the next few months? Almost assuredly. In my view, these moments are when investors should ensure they've got a bias (relative to their long-term plan) toward asset classes that can provide above-inflation returns. Interest rate sensitive categories like bonds and real estate don't fit the bill. On the other hand, the most hated category, stocks, is well positioned to deliver returns in excess of inflation, with the possibility of even fancier numbers if valuations improve.