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English Portfolio Management

A look into the market crystal ball

High valuations make it improbable to repeat the recent high returns in stocks and bonds and investors need to manage their return expectations accordingly.

Capital market assumptions (CMAs) are an essential prerequisite for sound asset allocation. CMAs are forward-looking estimates (usually over a decade) of future investment returns. More sophisticated CMAs also include volatilities and correlations of various asset classes. These forecasts will impact the portfolio weight of each asset class.

Global asset managers, investment consultants and banks usually develop their own CMAs and sometimes share them with the public. As a private investor, it is important to understand their mechanics, but you do not need to calculate them and can rely on sound public sources (such as those presented in the sources: AON and J.P. Morgan).

Long-term expected returns may be estimated in different ways*.

  • The main approach is to decompose total return into expected changes in income and market value based on different metrics (e.g. yields, spreads, valuation ratios).
  • Another approach is determine expected returns from a risk premium framework where asset-class-specific returns are determined relative to non-risky assets or the market portfolio.

Long-term CMAs are not intended to be tactical asset allocation tools or trading signals for speculative purposes. However, they do provide guidance on the relative attractiveness of various asset classes over the long term and are key inputs to asset allocation decisions.

The components of public equity return expectations are inflation, real earnings growth, dividend income, expected change in price/earnings valuations, and expected currency impact (for investments outside the domestic currency). As an example, a recent article in the Journal of Portfolio Management suggests that expectations for U.S. equities are around 5.5% (reflecting several other publications). This would correspond to an inflation forecast of 2.2%, growth of 1.8%, and dividend yield of 1.5%. This estimate is well below the realized return over the past decade but is consistent with the current high valuation of equity markets and the return expectations published by asset managers and consultants. The expected return for non-U.S. developed markets would be slightly above 6% and for emerging market equities around 8%. For J.P. Morgan, this coming cycle does not look positive “with equity valuations elevated and presenting a headwind for returns in many stock markets”. The impact of high valuations for U.S. large cap equities explains J.P Morgan’s lower return forecast on U.S. stocks (4.10%) and Emerging Markets equities (7.20%), which also performed well last year.

Fixed income assets reflect current yield, capital and income gains/losses due to yield curve movement. The expected yield of 1.0% for cash is very close to 1.5% for core fixed income. As with equities, expectations for bonds are below the performance of the past decade.

There seems to be a consensus that high valuations will make it nearly impossible to repeat the recent high returns in stocks and bonds. The argument for investing in stocks as a hedge against inflation remains valid, but investors need to manage their return expectations accordingly and make realistic long-term forecasts.

Additional hints for advanced readers:

When using CMAs to build portfolio, the absolute level of a return assumption is less important than the comparison to other assumptions: in fact, the spread between asset classes is key to changing weights between asset classes within a portfolio.

*There are other ways, such as a regression-based approach (Philips and Kobor (2020)) reflecting an adjusted price/earnings ratio and price/sales ratio, but both of the above approaches can be used with simplified assumptions for individual uses.

Sources: 
Strategic Asset Allocation for Endowment Funds, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Kathleen E. Jacobs and Adam Kobor
“2021 Long-Term Capital Market Assumptions”, J.P. Morgan, 2020, www.am.jpmorgan.com
“Capital Market Assumptions—As of 30 September 2020”, AON, 2020, www.insights-north-america.aon.com

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