Thinking About Returns

When it comes to investing one important part of risk is the potential for losses. So how can we think about the return if the future is uncertain?

Let’s use what is the difference between a safe asset - bonds, and a risky asset - stocks. 

And let’s use CAPE to assist in understanding the potential long terms returns and also the current potential losses. 

Here is where we currently sit. 

The theory goes that when interests rates are low, stocks are better value and therefore you can pay a higher price. For example, if interests rates are rates are at 1%, then companies can borrow cheaply and make more profit on their good and services. So stocks as a whole can look attractive when compared to bonds. Let’s say the earnings yield on stocks is 3.5%, meaning there is a premium of 2.5% for stocks over bonds (3.5-1=2.5). Thus, the company is more valuable and you can get a better return than just sitting in boring old bonds getting 1%. As interest rates rise though, stocks should be worth less and investors can move from stocks to bonds by rebalancing. Even if we have a high CAPE (38) like we do, if the yield on stocks is superior to bonds, then you should be more weighted to stocks. 

A time to replace stocks with bonds is when the CAPE is high and long term interest rates are rising - just like we have now. 

If we look at real, not nominal returns which includes inflation, we see that bonds are currently offering around 1.5% which is 4.42 minus 3% inflation (in fact inflation protected bonds are offering 1.89%). Not exactly smashing it out of the ballpark. However, the current earnings yield on stocks is 3.43%. Minus inflation of roughly 3% leaves us with an expected return somewhere around 0.5%.

Now since rates have risen and are expected to rise over the next decade, we should really be considering alternative investments that can deliver more real returns of more than 1.5% for bonds or 0.5% for stocks. That is why we look for cheap markets rather than the expensive ones. We don’t know when overvalued markets fall, but when the momentum slows, those expensive markets will likely be very unattractive when considering the meagre yields on offer. 

Remember if rates rise, and they most likely will since inflation will rise as a result of demographics and tariffs, then stocks look even more unattractive than they currently do.