Capital Market Assumptions

October 26, 2015

Table of Contents
3-5: Expected returns for 60/40
6-11: Implications
12-18: Capital market asumptions from
Schwab, JP Morgan, Northern Trust, AQR
and Bank of NY
19-21: FactSet data; corporate margins
22-27: Asset allocations used by institutions
28-29: Links to sources
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10-Year Expected Returns

SPY: 6.0%
AGG: 2.0%
60/40: 4.4%
Note: Expected returns include a projected inflation rate of 2.0%.
Returns are compounded for the ten-year period ending 12/31/26.

Methodology
Expected equity returns: 6%
= Dividend yield of 2.0%
+ Inflation of 2.0%
+ Real earnings growth of 2.0%
Expected bond returns: 2%
= SEC Yield on AGG of 2.0%

Track Record of This Methodology

Expected Returns Are Low: What Is Attractive?

Income:
Bond ladders or bullet ETFs
Fixed annuities: DIAs and SPIAs
Covered call writing
Diversification
Hedge funds: Structure and strategy depend
on account size and advisor expertise
Managed futures: Uncorrelated returns
Commodities: Long-term rebalancing
6

Enhanced Equity Returns

Private equity
Illiquidity premium
High dispersion requires heavy due diligence

Emerging market equities: Asia ex-Japan

UK equities: Low valuation and high
global exposure
High yield bonds: Proxy for equity
exposure
7

Enhanced Equity Returns: Factor Exposures

Value
Momentum
Quality: profitability measures such as
ROE and ROA
Carry: Defined as the initial yield of the
asset
Low beta: Reduces volatility more than it
enhances returns
8

What Variables Am I Watching?

Inflation
Drives both CMAs and financial plans
Focus on Employment Cost Index
Corporate Margins
Long-term margin expansion reflects lower
SG&A, taxes, and interest costs (slide 21)
Trends may have peaked
Balance Sheets and Backbacks
Debt levels and net cash (slide 20)
Buybacks (slide 19)
9

Tactical Overlay
Expected returns are low, and portfolio drawdowns are
devastating, so it sometimes makes sense to shift to cash.
Defensive Use of Cash
Cash is the gold standard for mitigating risk (and
client sanity)
Shift to cash on 2-sigma events (a work in process)
BUT tactical tilts undermine strategic diversification

10

Tactical Overlay: Methodology

Valuation: Provides information about risk
Momentum: Provides information about timing
Economic momentum: Dash of Insight
Earnings momentum: Fundamentalis and
FactSet
Price momentum: Long-term support on SPY
Monitoring Inflation, margins, balance sheets
Integrate, integrate, integrate
No framework = no results
11

Schwabs Retirement Assumptions

Intl stocks return less than U.S. stocks. Hmmm

12

JP Morgan: Expected Return Assumptions

Annual Volatility

Highest Expected
Returns

SPY

10-15 Year
Returns
6.5%

15.5%

AGG

4.0%

4.0%

Emg Mkts: 8.75%

Asia ex-Jap: 9.75%
High Yield: 6%
EM Sov: 7.5%

2.0% / 2.25%

1.5%

TIPS: 4.25%

7.75%

22.0%

An alpha class not

an asset class.

6% to 7.75%

12% to 15%

Value-added U.S.
RE: 7.75%

Diversified HFs

4.5%

5.75%

Long-bias hedge
funds

Commodities

3.5%

19.0%

Gold: 4.0%

Cash / Inflation
Private Equity
Real Estate

https://am.jpmorgan.com/gi/getdoc/1413613727995
13

JPM: Components of Equity Returns

14

Northern Trust
5-Year Returns

Highest Expected Returns

SPY

5.6%

Global: 6.5% UK: 7.0%, EM Asia: 8.5%

AGG

3.0%

High Yield: 5.6%, EM Debt: 6.5%

Cash

1.5%

TIPS: 2.4%

Private Equity

8.6%

Venture Capital: 9.7%

Real Estate

6.9%

Diversified HFs

4.4%

Commodities

5.0%

Long-bias hedge funds

The Northern Trust 2015 report on CMAs focuses on investment themes.

On page 11 the report cited historical return premia from factor exposures such as
quality and value. These premia have ranged from 3% to 7%.
In a low return environment, I expect return premia of more like 1% to 3%.
15

AQR: Equities
(Page 2 of 1Q 2015 report; timeframe is 5 to 10 years)

AQR uses a dividend discount model and the Shiller P/E. Both approaches reach
roughly the same conclusion about expected returns: DDM projects 3.5% and
Shiller P/E projects 4.0%.
I add 0.5% to the DDM to account for the buyback yield since I believe that recent
buyback trends will persist.
16

AQR: Fixed Income

Page 3 of 1Q 2015 report

1Q 2015

If the yield curve

is unchanged, a
bond rises in
price as it rolls
down the
curve.

AQR projects real returns of 0.6% for U.S. 10-year bonds.

The steepness of the yield curve does NOT accurately predict rising rates. History
shows instead that the steepness reflects a term premium for LT bonds.
Nominal yields do NOT tend to revert to the mean due to the persistence of
inflation, when it occurs.
Outlook argues for buy-and-hold portfolio of bonds or target-duration ETFs.
17

Bank of NY: Equity Returns

Dividends +
buyback
yield (see
next page)
2.6% real
EPS growth
2.2%
inflation

18

What Is Buyback Yield?

Page 8 of Buyback Quarterly 9/21/15

2.6% real
EPS growth is
too high.

FactSet Data show that corporations have been net buyers of stock over the last
ten years (especially tech firms). This boosts returns, just as dividend yield does.
I expect this to persist, and add about 0.5% to long-term equity returns.
19

Levering Up: Not Captured in DDM

(Page 12 Cash and Investment 9/24/15)

Net corporate debt issuance has reached more than $100 billion per quarter.
This has occurred even as cash on balance sheets hits $1.4 trillion .
In 2Q 2015, the three biggest issuers of debt were:
AbbieVie: $16B
AT&T: $15B
Apple: $11B

20

Falling SG&A Has Boosted Margins

SG&A has have fallen from 24% to 16% from 1990-2013.

Can this continue?
Source: Figure 14, Why Jeremy Grantham Is Right About Corporate Profit Margins, Advisor Perspectives,
11/11/2014
21

What Do Wealth Managers Recommend?

2015'Asset'Alloca=ons:''
Average'of'41'Top'Wealth'Managers'

Fixed'Income'
27%'

Cash'
3%'

Alterna=ves'
19%'

Equity''
51%'

Private'
Equity'
3%'

Hedge'Funds'
10%'

Real'
Estate'
3%'

Other'
1%'

Commodi=es'
2%'

Source: PCM Partners, LLC,

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proprietary database.

Wealth Managers Asset Allocations:

Summary Statistics
20152Asset2Allocation:
Summary2Statistics2for2412Top2Wealth2Managers
Average
Median
Std.+Dev.
High
Low

Equity
51%
50%
8%
67%
37%

Fixed+
Income
27%
28%
8%
44%
10%

Cash+
3%
3%
2%
9%
0%

Alts
19%
20%
9%
35%
0%

Real+
Estate
3%
2%
2%
10%
0%

CMDT
2%
2%
2%
6%
0%

Hedge+
Funds
10%
9%
7%
28%
0%

Private+
Equity Other+Alt
3%
2%
3%
0%
4%
4%
14%
20%
0%
0%

Source: PCM Partners, LLC, proprietary database.

Recommendations tend to cluster around the same asset allocations.

This may reflect overconfidence in Mean Variance Optimization.
If it is herd behavior, a contrarian position may make sense.
23

BoNY Allocations for Institutions

24

Pensions Are Optimistic

To get 7.4% returns

from a 60/40 portfolio,
you must assume
9% for stocks and
5% for bonds.

Source: Distribution of Alternative

Investments through Wirehouses,
May 2015.
25

A Dose of Reality from BoNY

26

CALSTERS Expects History to Repeat

To get 7.4% returns

from a 60/40 portfolio,
you must assume
9% for stocks and
5% for bonds.

Wow!

CALSTERS manages $190 billion, and is an example of optimistic assumptions for expected returns.
The portfolio returned 7.7% for the 10 years ending 6/30/14. This included returns of 8.3% on
global stocks, 5.5% on fixed income, 7.4% on real estate, and 13.8% on private equity.
Sources: California State Teachers Retirement System (CALSTERS) Investment Policy and Management
Plan, 2014 November, page 10; CALSTERS Annual Financial Report page 135
27

Resources
1. Expected Returns by Research Affiliates from 2012. Shows returns
from a 60/40 portfolio for 14 decades.
2. Schwab assumptions used in retirement calculator. Also see this
article from April 2015.
3. JP Morgan: See page 60 for equities
4. Northern Trust: Thematic approach
5. AQR Library: Meticulous financial theory, esp. Alternative Thinking
6. Distribution of Alternative Investments Through Wirehouses,
Money Management Institute, May 2015.
7. Bank of New York
8. CALSTERs Investment Policy and Management Plan.
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Research Links
1. McKinseys bearish report on global corporate
margins. It got lots of press but I prefer
2. Deconstructing corporate margins: Ramraika/
Trivedi. Uses a granular, bottom-up approach.
3. FactSet Cash and Investment Quarterly. Tracks cash
and debt, as well as capex and R&D. Also see FactSet
Buyback Quarterly and FactSet Dividend Quarterly.
4. Dash of Insight by Jeff Miller
5. Fundamentalis by Brian Gilmartin
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