(As of Nov. 6, 2023)
October 2023 was a rough month for investment returns, with asset class returns in these ranges (as implemented via Dimensional Funds Advisors’ mutual funds and ETFs):
U.S. Large Company stocks: – 1.6% to -4.2%, approximately
U.S. Small Company stocks: – 4.8% to -6.5%, approximately
Foreign Developed Markets Small Cap stocks: – 3.6% to 5.2%, approximately
Emerging Markets stocks: – 3.6% to 5.5%, approximately
Past performance is not a guarantee of future performance. Data represents the returns of various Dimensional funds and ETFs, in each broad asset class. Within each asset class are varying degrees of exposures to the profitability, value, size, investment, and momentum factors. No deduction is made for the fees charged by Scholar Financial, LLC, nor any transaction costs which may be incurred with a custodian (i.e., Charles Schwab, etc.).
Generally, growth stocks outperformed value stocks during the month of October 2023. Large company stocks generally outperformed small company stocks. And the profitability factor also subtracted from returns. In other words, factor-based investing did poorly during the month of October.
Yet, periods of underperformance for factor-based investing are to be expected. In fact, such periods can last for years, or even decades. Even over any given 20-year period, factor-based investing does not guarantee higher returns. In fact, the best expression I can offer of the expected added returns is the following:
“A multi-factor-based investment approach, using the small cap (size), value (price), high profitability, low investment, and momentum factors, successfully implemented in a manner that reduces securities trading within a fund, possesses an 80% or greater probability of outperforming a total stock market index, over any given 20-year period of time.”
While the historical probability of outperformance is greater, I state the probability going forward as only “80% or greater” given the fact that the future is not always the same as the past, and also given that once factors are discovered there is evidence that returns from the factors diminish by about one-third. In addition, a factor may commence a 20-year period with a very high valuation level and end the 20-year period at a very low valuation level, resulting in potential underperformance.
Valuations and Expected Longer-Term Returns: Equities
I again present data from Research Affiliates, a firm that does, in my view, an exceptionally good quantitative analysis of the valuations of various equity (stock) asset classes. Below is a chart setting forth data from Research Affiliates, as of October 31, 2023. With stock asset class returns generally negative during the month of October, I also show the impact of the fall of stock prices by showing the increase in the expected returns (mean projection), from the September 30, 2023 data.
Additionally, I set forth additional asset class return projections from my own computations (for U.S. stock asset classes only).
| ASSET CLASS | As of Oct. 31, 2023, Expected 10-Year Nominal Average Annualized Returns Per Research Affiliates’ Asset Allocation Interactive | As of Nov. 2, 2023 Expected 10-Year Nominal Average Annualized Returns Per Ron A. Rhoades Using Price-Book Data | ||
| 5% probability of returns less than: | Mean Projection of Expected Returns: | 5% probability of returns greater than: | Mean Projection of Expected Returns | |
| U.S. large company stocks | -0.9% | 4.9% (+0.3% in one month) | 10.6% | 5.5% |
| U.S. large company value stocks | 1.5% | 7.3% (+0.3% in one month) | 13.1% | 6.0% |
| U.S. small company stocks | 0.3% | 7.9% (+0.6% in one month) | 15.4% | 8.5% |
| U.S. small company value stocks | 1.7% | 9.2% (+0.6% in one month) | 16.8% | 10.0% |
| Developed markets (ex-U.S.) stocks | 4.0% | 10.2% (+0.4% in one month) | 16.3% | — |
| Developed markets (ex-U.S.) value stocks | 5.4% | 11.9% (+0.3% in one month) | 18.3% | — |
| Developed markets (ex-U.S.) small company stocks | 4.1% | 10.8% (+0.5% in one month) | 17.6% | — |
| Developed markets (ex-U.S.) small company value stocks | 5.8% | 12.4% (+0.5% in one month) | 19.0% | — |
| Emerging markets stocks | 3.2% | 10.8% (+0.2% in one month) | 18.4% | — |
These are estimates, or projections, only, and are NOT a guarantee of any future returns. There is a distinct possibility that the returns of one or more of the asset classes may be significantly lower, or significantly higher, than the range of estimates provided for that asset class, as set forth above.
Stock returns can be affected by many factors, including but not limited to changes in valuation levels with ending results significantly above or below the historical average levels, changes in tax policies, changes in interest rates, changes in the rate of inflation, changing investor perceptions and appetites for risk, and many different macroeconomic factors. All the returns shown are gross nominal expected returns, prior to any deduction for mutual fund / ETF or other fees, expenses, transaction costs within a fund, and the fees of any separate (from the fund) investment adviser. Nominal returns also do not reflect the impact of taxes which may occur, depending upon the type of account in which the investments are held, along with other factors. You cannot invest directly into an asset class; investments must be made by purchasing securities (individual securities, mutual funds, ETFs, etc.).
SOURCE OF DATA: Research Affiliates, Asset Allocation Interactive (as of Sept. 30, 2023). Please note that the outcomes stated are hypothetical in nature, and that neither Research Affiliates nor its Asset Allocation Interactive tool, in presenting this data, is recommending any specific securities (stocks, bonds, funds, etc.).
SOURCE OF DATA: Scholar Financial, LLC, using proprietary data set employing a mix of data from Russell indices, Fama/French research indices (with adjustments for implementation costs), actual returns from 8/1996-8/2023 of DFA US Large Cap Value, DFA US Small Cap, and DFA US Small Cap Value portfolios (funds), and price-book ratios of iShares ETFs that track the Russell indices. Adjustments are then undertaken to future expected returns (in contrast to historic returns) because of lower working-age population growth in the U.S., as well as greater consumer and government debt levels, which will each likely serve as drags upon U.S. economic growth and, hence, equity returns. Additional adjustments are made to small cap and value returns as a result of greater utilization among funds and practitioners of these factors, which tends to lower expected returns.
As seen in the chart on the preceding page, while small cap stocks fell further in October, in terms of their pricing, the expected returns of small cap stocks (in both U.S. and foreign developed markets) increased to a greater degree from Sept. 30th to Oct. 31st than the increase in the expected returns of large company stocks.
Using Ron’s methodology, which is based upon price-book valuation ratios for U.S. stock asset classes, using the Russell 2000 indices, it appears that at present U.S. small company and small cap value stocks are undervalued at present. In contrast, U.S. large cap growth stocks appear to be substantially overvalued at present. This, in turn, causes U.S. large company stocks (which make up about 80% to 85% of the total market capitalization of U.S. publicly traded stocks on the major exchanges) to be significantly overvalued. U.S. large cap value stocks appear to be somewhat overvalued, relative to historic levels.
Turning to another measure of the valuation levels of the broad U.S. stock market, the S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio of the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings. The metric was invented by American economist Robert Shiller and has become a popular way to understand long-term stock market valuations. It is used as a valuation metric to forecast future returns, where a higher CAPE ratio could reflect lower returns over the next couple of decades, whereas a lower CAPE ratio could reflect higher returns over the next couple of decades, as the ratio undertakes a reversion to the mean. As of close of trading on Nov. 3rd, the ratio stood at 29.50 much higher than its mean (since 1870) of 17.07. However, various studies of p/e ratios utilization in valuations have suggested that a “normal” level of the CAPE ratio for the S&P 500 Index should lie between 20 and 25, due to changes in accounting policies and for other reasons. Still, the CAPE ratio suggests an overvaluation for U.S. large company stocks of 20% to 30%, or higher, at the present time.
Another valuation measure of the overall U.S. stock market is the Buffett Indicator (aka, Buffett Index, or Buffett Ratio) is the ratio of the total United States stock market to GDP. As of October 31, 2023, the ratio is calculated as:
Aggregate US Market Value: $44.36T / Annualized GDP: $27.65T
Buffett Indicator: $44.36T ÷ $27.65T = 160%
The current Buffet Indicator ratio of 160% is said to be in the “significantly overvalued” range, resulting in expected returns for U.S. stocks being in the low single digits for the next 10-year period, assuming mean reversion occurs over that period. Again, the primary cause of this overvaluation is U.S. large company growth stocks being overvalued at present.
Again, I want to emphasize that there is nothing certain in the data presented above. Indeed, there is a broad range of possible outcomes, wholly dependent upon economic growth in various countries, changes in tax and other policies, and the endpoint (10 years from now) in valuations. Rarely does the endpoint attain reversion to the exact mean, as predicted in the “mean projection of expected returns” column in the foregoing chart. In other words, estimates of future stock returns are just that – estimates. There is a broad range of potential returns, and the “mean” return that is shown, while indicative of the best guess, is still a guess made through the lens of a very cloudy crystal ball. All this means that diversification among asset classes – and among the world’s various capital markets – remains a key tenet for investors.
There is no perfect, or even exceptionally great, method of undertaking projections of future returns. For example, the mean of valuation ratios changes over time, whether due to changes in corporate policies, the need for capital assets, or long-term changes in the perceptions of investors as to market or other risks. Additionally, once a factor is widely known, some evidence suggest that investors react to the knowledge of the factor by adjusting valuation ratios, although this adjustment is not full (and perhaps less than 50% of the expected excess returns of a factor). Macroeconomic factors, including long-term changes to tax policies, the impact of technology (robotics, computer software including artificial intelligence, etc.), can possess a tremendous impact on the profitability of certain industries in the future, often in unpredicted ways.
But, despite the uncertainty, it is good to have a likely statistical advantage. In other words, over the next 10 years, evidence-based equity investing, and particularly the value stock strategy, looks highly appealing. In contrast, the S&P 500 Index®, which is followed (and invested in) by many investors, looks likely to underperform its historic average annualized return (since 1926) of between 9% and 10% (on average, over very long periods of time), and possesses an expected (median) average annualized return of only 4.9% over the next 10 years.
Bond Yields
The U.S. Treasury bond yields have risen significantly from six months ago. As bond yields rise, the value of bonds fall. The longer the duration of the bond, the greater the fall in price.
As of early last week, U.S. 30-Year Treasury bonds had lost 57% of their value, from just a few years ago, due to the rise in interest rates from historically low values.
Fortunately, I suggest bonds (and bond funds) with much lower maturities (and much lower duration), which has tempered the losses in the fixed income portion of the portfolio over the past six months. Still, a hit was seen, even to short-term bond funds. For example, over the past three years (as of 10/31/2023), the DFA Short-Term Extended Quality Portfolio, a bond fund with a current average duration of only 0.85 years (although the duration varies, and has been in the 2-3 year range in past years), had an average annualized return of -0.55%. The Vanguard Short-Term Corporate Bond Index Fund had a 3-year average annualized return of -1.18% as of 10/31/2023. (These are illustrative only, of short-term bond fund returns. Other bond funds, with lower or higher returns, as well as other types of fixed income securities, may be utilized in client’s accounts.)
Over the past few days (as of the day of this writing, Nov. 6th), bond yields have fallen somewhat, due to a change in Federal Reserve policy on the types of bonds it sells, as well as due to various economic news.
The good news is that yields have risen, with shorter-term bond funds often yielding more than 5% at present. If interest rates were to continue to rise, the downside risk is lesser (as the price falls less, when interest rates go from 5% to 7% for example, versus interest rates rising from 3% to 5%). And there is upside potential in bond prices, if interest rates were to fall.
Economists have very different opinions on bond yields. Some economists predict some form of recession in 2024, with bond yields falling (and bond prices rising). According to a survey done by the Wall Street Journal in October, roughly half of the economists surveyed expected the Federal Reserve to start reducing interest rates in the second quarter of 2024.
Other economists, however, believe inflation is not yet under control, and due to the ongoing fiscal stimulus (i.e., large federal deficits) the Federal Reserve will again hike its Federal Funds rate in December 2023 and/or in 2024 (which, in turn, would increase bond yields in the marketplace).
In Conclusion
Due to the present relative valuations between growth stocks and value stocks, and large company and small company stocks, a multi-factor approach, employing the size factor (small-cap risk premium), price factor (value risk premium), profitability factor (or its cousin, the quality factor, which is defined in different ways), and aided possibly by other factors, likewise has a very strong probability of outperforming broad market funds over the next 10-20 years. As discussed in prior editions of this newsletter, the employment of multiple factors (selected for their academic support) when designing overall investment strategies will tend to smooth out performance when any one factor disappoints.
October 2023’s poorly performing stock market boosted the long-term expected returns of various asset classes. This does not mean that stocks cannot fall a great deal further, in the shorter-term (even over several years). There is a very low correlation between current asset valuation levels and future actual returns over 1-year, 3-year, and 5-year periods.
There are very, very few investment strategies that are strongly supported by the academic evidence. For example, while there are many hundreds of “factors” – less than a dozen have received widespread support for being robust, relatively persistent, and investable.
Even if interest rates were to continue to rise from present levels, most of the pain of interest rate increases is likely behind us. Bonds and other fixed income investments of high quality provide a degree of stability to a portfolio, especially U.S. government bonds during severe recessions or economic depressions. After many years when bond interest rates were quite low, bond yields have returned to what some might call a “normal range,” and bonds again can contribute significantly to the overall returns of an investment portfolio.