looms, however now is a good time to reset long-term investment return expectations for participants. In fact, California’s state public pension system, Calpers, recently lowered their expectations for long-term investment returns from 7.5 percent to 7 percent.³ Even those reduced projections may prove optimistic.Equity returns are primarily a function of three factors: earnings growth, the multiple paid for earnings, and dividends. Earnings have benefitted from near-record corporate profit margins.⁴ Since the Great Recession, corporate profit margins have expanded on the back of cost cutting, low labor costs and low interest rates. This margin expansion has fueled earnings growth and any reversion to the mean would create a headwind for earnings going forward.⁵ Furthermore, the current price-to-earnings ratio⁶ for the S&P 500 is about 18 times forward earnings. That compares to a historical 25-year average of about 16 times earnings.7 These valuation levels are not extreme yet provide less opportunity for future multiple expansion to drive returns. Lastly, the current dividend yield on the S&P 500 is less than 2 percent compared to a historical median yield of over 4 percent.8 For all of the above reasons, U.S. equity returns in the high single digits are unlikely over the coming years from this starting point.
Expect returns from fixed-income investments to also be challenged going forward. The most significant component of fixed income returns are yields. During this secular bull market in bonds, returns have been bolstered by falling interest rates. The current yield on 10-year treasuries is about 2.5 percent. That compares to an average historical nominal yield of over 6 percent.9 Additionally, if or when rates eventually rise, bond prices will be pressured since bond prices move inversely to interest rates. Clearly with yields near historically low levels, expect fixed income investments to return less than they have historically.
This is by no means a signal to exit the market and go to cash. Market timing is a fool’s game because it is impossible to properly time an exit and entry back into the market. As history has repeatedly shown, investors who try to time the market are destined for inferior returns over time. However from the current starting point, it is difficult to envision a balanced portfolio achieving high single digit returns over the next five to 10 years. A low to mid-single-digit return is a more realistic expectation.