Monday Morning: Continuing storm seen diluting returns

The past five months have been, in the words of one observer, a perfect storm in the financial markets. A bear market brought on by the collapse of the Internet bubble was compounded by Sept. 11, the Enron scandal, the indictment of Arthur Andersen and revelations of suspect accounting at dozens of companies.

The question is, are we near the end of the storm or simply near the eye of the hurricane?

According to Robert D. Arnott, managing partner at First Quadrant LLP, a money management firm in Pasadena, Calif., with $14.7 billion under management, the current situation may get worse before it gets better. We are still nearer the eye of the hurricane than its edge, he believes.

“We have an array of risk factors that are largely unaccepted by the investment community and therefore are not reflected in market prices,” he says.

For example, by historical standards, stock market valuation is still high. Using 10-year average earnings (to take out the impact of peak and trough earnings) the price-earnings ratio of the market has fallen from unprecedented levels down to “the same levels that prevailed at the 1929 peak,” he says.

In addition, based on reasonable earnings growth assumptions and today’s modest dividend yield, “stocks can’t be expected to substantially outpace bonds in the years ahead, and might well lag bonds,” he adds.

Mr. Arnott notes that some Wall Street firms have calculated that stock options, if properly accounted for, would have reduced reported corporate earnings in 2000 by between $50 billion and $100 billion.

In addition, pension expense, using a 6% return assumption on pension assets rather than the 9% used by most companies, would have reduced 2000 earnings by another $50 billion.

The impact of both of those factors would have been to reduce peak corporate earnings in 2000 from almost $60 per share for the Standard & Poor’s 500 stock index companies to $40 a share. For 2001, with the S&P companies reporting earnings of around $25 a share, the impact of the two items would have reduced true earnings to close to zero.

Then, he notes, the dividend payout ratios for stocks is very low by historical standards, and low payout ratios usually are followed by poor earnings growth, not strong earnings growth.

Finally, demographics are beginning to work against the markets and the economy, with baby boomers beginning to disinvest in just a few years. “Society can’t afford to have them (us) all retire at 65,” he notes.

Mr. Arnott has come up with some sobering long-term return forecasts for various asset classes based on the above factors and others.

For large-cap stocks, he expects an average yield of 1.5%, real growth of earnings of 1.5%, and inflation of 2.5%, giving a total return of 5.5% per year, long term. But for the next three years, he expects the market prices of large-cap stocks to fall by 5 percentage points a year as stock prices revert toward the mean, giving a return of only half a point per year.

In the long term, international stocks and small-cap U.S. stocks should return 6% per year, but over the next three years, because of mean reversion, only 3%. Emerging-market stocks, Mr. Arnott believes, will return 8.5% long term and 6.5% over the next three years. Real estate should return 6.5% long term and 7.5% over the next three years.

He expects long-term government bonds to return 5.5%, double-A corporates 6% and high-yield bonds 8%, both long term and over the next three years.

TIMBER!!!

The best returns, both near term and long term, Mr. Arnott estimates, will come from absolute return (e.g., long-short) strategies, up to 10%; timber investments, 9.5% near term and long term; and Treasury inflation-protected securities, which should provide 6% long term and 8% over the next three years.

Given the returns investors gained in stocks in the 15 years through 1999, none of those figures is very exciting, and Mr. Arnott could be wrong in his analysis. But the prudent investment adviser would do well to take them into consideration when devising financial plans for clients.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.