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.

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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%    

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5

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

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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

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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

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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)

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Tactical OverlayExpected  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    

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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

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Schwab’s Retirement Assumptions

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Int’l  stocks  return  less  than  U.S.  stocks.    Hmmm…

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JP Morgan: Expected Return Assumptions   10-­‐15  Year  

Returns  Annual  Volatility Highest  Expected  

Returns

SPY 6.5% 15.5% Emg  Mkts:  8.75%  Asia  ex-­‐Jap:  9.75%

AGG   4.0% 4.0% High  Yield:  6%  EM  Sov:  7.5%

Cash  /  Inflation 2.0%  /  2.25% 1.5% TIPS:  4.25%

Private  Equity 7.75% 22.0% An  “alpha  class”  not  an  asset  class.

Real  Estate 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%

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

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JPM: Components of Equity Returns

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Northern Trust5-­‐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% Long-­‐bias  hedge  funds

Commodities 5.0%

• 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%.

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AQR: Equities

• 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.

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

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AQR: Fixed Income

• 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.

1Q  2015

If  the  yield  curve  is  unchanged,  a  bond  rises  in  price  as  it  “rolls  down”  the  curve.

Page  3  of  1Q  2015  report

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Bank of NY: Equity Returns

2.6%  real  EPS  growth  

Dividends  +    “buyback  yield”  (see  next  page)

2.2%  inflation

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What Is “Buyback Yield”?

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.

Page  8  of  Buyback  Quarterly  9/21/15

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Levering Up: Not Captured in DDM

• 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

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

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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

22Source:  PCM  Partners,  LLC,    proprietary  database.

What Do Wealth Managers Recommend?

Equity''51%'

Fixed'Income'27%'

Cash'3%'

Real'Estate'3%'

Commodi=es'2%'

Hedge'Funds'10%'

Private'Equity'3%'

Other'1%'

Alterna=ves'19%'

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

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Source:  PCM  Partners,  LLC,  proprietary  database.

Wealth Managers Asset Allocations: Summary Statistics

EquityFixed+Income Cash+ Alts

Real+Estate CMDT

Hedge+Funds

Private+Equity Other+Alt

Average 51% 27% 3% 19% 3% 2% 10% 3% 2%Median 50% 28% 3% 20% 2% 2% 9% 3% 0%Std.+Dev. 8% 8% 2% 9% 2% 2% 7% 4% 4%High 67% 44% 9% 35% 10% 6% 28% 14% 20%Low 37% 10% 0% 0% 0% 0% 0% 0% 0%

Summary2Statistics2for2412Top2Wealth2Managers20152Asset2Allocation:

• 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.

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BoNY Allocations for Institutions

Pensions Are Optimistic

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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.

A Dose of Reality from BoNY

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CALSTERS Expects History to Repeat

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To  get  7.4%  returns    from  a  60/40  portfolio,    you  must  assume    9%  for  stocks  and    5%  for  bonds.

Sources:  California  State  Teachers  Retirement  System  (CALSTERS)  Investment  Policy  and  Management  Plan,  2014  November,  page  10;      CALSTERS  Annual  Financial  Report  page  135  

• 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.

Wow!

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. McKinsey’s  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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