A lost decade for stocks?

Looking for big returns from your stocks over the next 10 years? Forget it! It’s just not going to happen, says the chief institutional strategist of RBC Capital Markets, Myles Zyblock.

It is highly unusual for a major brokerage firm to come out with a report that essentially tells clients that stock market profits are going to be minimal at best for a decade. So when the April 20 issue of RBC’s Investment Strategy Weekly popped up on my computer screen last week, it certainly caught my attention – especially the subtitle which reads: “Peering into the next ten years: You aren’t going to like what you see.”

Using two different methods of forward market analysis, Zyblock concludes that both the Canadian and U.S. markets are going to be disappointing places for your money unless you adopt an active, in-and-out investment approach.

“Buy and hold strategies and indexing will probably deliver sub-par returns,” he and his associates write. “In contrast, astute stock picking and concentrating the number of stocks held in portfolios should provide the best opportunity to enhance returns in future years.”

The best and the worst&ltbr/>Exactly what does the RBC team mean by “sub-par returns”? How about 0.4 per cent annually on the S&P 500, which is comprised of America’s 500 largest corporations? That’s the worst of the modeling forecasts but even the best scenario isn’t a lot better: a 2.7 per cent annualized total return for the S&P 500 and a 2.9 per cent figure for the S&P/TSX Composite over the decade. No one is going to get rich that way!

The analysts used two methods to arrive at their projections. The first was based on the historical relationship between price/earnings ratios (P/Es) and future stock market returns. The second used an accounting-based methodology, breaking the return on investment into its different components. The bottom-line numbers differed but the overall pattern was the same – below-average returns. Here’s how the report summarized the findings:

The P/E method: “P/Es are strongly and inversely related to subsequent long-term returns. With the help of a simple regression model, we estimate that the S&P 500 at current valuations is priced to deliver about 0.4 per cent in total return terms per annum over the next decade. Unfortunately, we could not conduct a similar exercise for the Canadian market due to the lack of historical data.”

The accounting method: “An accounting-based approach delivers an expected annualized total return of 2.7 per cent for the S&P 500 and 2.9 per cent for the TSX Composite over the next decade. Here we assumed that dividends would continue to grow at a trend pace, and that dividend yields would rise in the next 10 years up to where they were a decade ago.”

The conclusion: “We are most likely going to see a substantial return shortfall in the broad North American indices over the next decade relative to what investors have become accustomed to.”

Others appear to agree
This is not an isolated view. Several major speakers expressed a similar long-term outlook for the U.S. stock market during the recent World Money Show in Orlando, Florida. Of course, such gloom is not universal but investors need to be aware that there’s a lot of pessimism out there at present. Forecasts of a 15,000 Dow any time soon are becoming hard to find.

Of course, this does not mean that you won’t be able to make any money in the stock market. The message that Zyblock is sending is that you will have to pick your spots carefully and be prepared to take profits as you go. There will always be winners, even in a flat or falling market.

The report’s reference to index funds, which would include exchange-traded funds (ETFs), is interesting. These have become extremely popular with investors because of their simplicity, transparency, and low cost. However, based on this prognosis, you may want to think twice before using broadly-based index funds as your core investments. Personally, I have never been convinced that relying exclusively on index funds is a wise strategy.

Diversify, diversify, diversify
If you take the findings of reports like this seriously (and I certainly do), it makes the case for portfolio diversification even more compelling. If stocks do poorly, bonds are likely to perform well and should be well-represented in your holdings. Income trusts don’t figure in the RBC analysis but the yields they offer suggests that they are likely to outperform equities on a total return basis over the next decade. Gold prices will be determined by much different factors than those driving the stock market.

Of course, certain categories of equities may buck the trend. If oil prices stay high, energy stocks will remain strong. Low interest rates would give a boost to financial institutions and utilities. There will always be special situations to watch for.

And the RBC analysis only considers Canada and the U.S. It’s a big world out there and we can reasonably expect that growth in countries like India, China, and Brazil will greatly exceed returns on Wall Street and Bay Street – albeit with much higher volatility.

So don’t allow yourself to become too depressed by the RBC forecasts. Rather, treat the report as a wake-up call. The heady stock market days of the 1990s are unlikely to return any time soon. It’s time to refocus and move on.