John Bogle recently got asked by Benzinga what kind of returns investors should expect over the coming decade. He assumed that investors owned a portfolio of 50% large stocks (index-fund based) and 50% bonds (U.S. government issued). He argued that he expects 5% earnings per share growth, 2% dividends, and -3% returns due to valuation compression from the S&P 500 as a whole. He expects the P/E ratio to switch from nearly 20x earnings to 15x earnings. This amounts to a 4% return from the stock portion of a portfolio.
With bonds, Bogle is predicting 3% annual returns over the next couple years. The implication is clear: Someone owning a portfolio equally stuffed with typical S&P 500 stocks and U.S. government bonds should expect 3.5% annual returns over the next ten years, and that may very well amount to 0% purchasing power gains when you include the effects of inflation, taxes, and the transaction costs. Bogle’s vision, if true, means that people setting aside money today would have no real gains between 2015 and 2025. In Buffett parlance, you wouldn’t be able to buy any more cheeseburgers in 2025 than you can today if Bogle’s prediction comes true.
The first question from Bogle’s prediction that we should consider is this: How likely is it that bonds will return 3% or so over the next ten years? Well, if you buy a ten-year T Bill today and hold it to maturity, you are guaranteed to generate 2.41% returns. It would certainly be better to load up on things like EE Bonds and I Bonds first because the interest forfeiture associated with selling early would give you greater protection compared to someone buying T-Bills who would have to deal with a low value compared to par at the time of sale if interest rates rose rapidly.
Bogle’s bond prediction may prove pessimistic rather than realistic if an investor is contemplating building a laddered bond portfolio over the next ten years and interest rates rise over this time frame. Given that interest rates are still hovering around historic lows and Fed Chair Janet Yellen indicated an interest rate hike within a year, it seems more likely than not that investors will be able to build a laddered portfolio of bonds yielding 4% and 5%.
The catch is that bonds purchased now, while rates are lower, have the greatest amount of time to compound and will exert a disproportionate pull on the blended rate of return. For instance, purchasing a 2.41% bond in 2015 will have ten years to compound during Bogle’s time horizon, but someone purchasing U.S. government bonds yielding 5% in 2021 will only have four years of compounding during Bogle’s projected period. Even if an investor aims to ladder their investments, Bogle’s 3% return prediction is more likely to come true the longer The Fed delays its rate hikes.
The second matter worthy of discussion from Bogle’s prediction is the premise itself. He assumes that an investor has half his wealth tied to U.S. bonds. Should this be followed?
The answer to almost every investment question, just like the answer to almost every legal question, is: “It depends.” Job, net worth, comfort zone, health—all those factors come into play. Probably the best way to think about the spectrum of possibilities is this: Are you trying to build wealth or preserve wealth? Answering that question honestly can provide a lot of guideposts to help you find the right strategy.
If you have built up something considerable over the course of a working career, the objective is probably asset preservation because there aren’t many couples with $10M account balances that need “more.” That’s the territory where your household generates $25,000 per month in passive income without trying.
A 50% bond allocation could be useful if you are worried about a 1929, 1973, or 2008 type of bear market occurring during your retirement years. The $5,000,000 bond allocation grows to $5,150,000 assuming continued bond payments from the U.S. government. Meanwhile, a true market crash that brings the S&P 500 down 50% would reduce the stock portion of such a portfolio to $2,500,000. A worst case scenario stress test would leave you with $7,6150,000 at the low point, for a wealth reduction of 23.85%.
Most likely, you’d still be collecting some dividends from the strongest S&P 500 companies during such a market crash, so the realistic worst case scenario is a 20% paper loss. That’s a nice trade-off for someone that wants to increase their purchasing power by a little bit during retirement but doesn’t want to jeopardize their life’s work at the end of it. For investors that are switching from exchanging their time for labor income towards living off investments, the 50% bond portfolio may make sense.
For someone who is trying to get rich, and expects to rely more on investment performance than accumulated savings to get there, the 50% bond allocation does not make sense to follow. You can’t get rich with 2.41% T-Bills. At best, a bond portion of a portfolio can only currently maintain purchasing power. The existing rates will not build wealth.
And this is where Benjamin Graham’s advice enters the picture. Interestingly, Graham’s advice to the average investor is that he should always maintain a 25% minimum allocation to either stocks or bonds at all times. You should keep in mind that Graham made this recommendation for pragmatic, psychological reasons rather than mathematical ones.
The inference from Graham’s writings is that he would look at something like John Deere stock or Aflac stock, see the superior returns over long periods of time attached to the 75% fluctuations from peak to trough over market cycles, and conclude that there is no way the average investor could handle such a fluctuation. And he saw bonds as a shock absorber that would keep people in the game by minimizing fear-based decisions.
Someone with $100,000 trying to turn it into $2.5 million would own $75,000 stocks and $25,000 bonds as the most stock-heavy portfolio that Graham would advise. If you run it through a 50% decline, the stock portion would become $37,500 while the bond portion would become $25,750. You’d have a $63,250 portfolio value during the worst of it. Graham thought investors could handle a 37% decline during crisis but would panic and sell during a 50% decline, and this difference explains why he advised bond allocation minimums even when the terms of a bond investment ensured mediocre absolute performance.
That said, Graham never saw 2.41% T-Bills in his lifetime. His ultimate advice, applied to every investment opportunity, is the question “At what price? And on what terms?” For people that are truly immune to stock price fluctuations, and would love to buy Procter & Gamble at $35 or Coca-Cola at $20, it may result in better real-world outcomes to ignore Graham and Bogle’s recommendation to have a meaningful portion of a portfolio in bonds.
The hard part is having the discernment ability to know when you truly are an exception to a general rule. Look at the people who have run away from Chevron now that the price of the stock has fallen from $135 to $102. It has a dividend history dating back to 1882, owns $180 billion in proven reserves, and is associated with the production of 2 million barrels of petroleum products per day. Fluctuations—boom and bust cycles—are entirely a part of its history, and Jeremy Siegel has even used the company as a seminar example of how dividends reinvested during market downturns result in higher absolute wealth than if the downturn never happened (this is because the price decline of the stock overshoots the temporary fundamental deterioration of the business.)
If you are running to something like Chevron and its 4% dividend yield right now, you may be an exception to Bogle and Graham’s general bond advice. If you are not excited about something like Chevron? Then I would try to be introspective and figure out whether I actually demonstrate the ability to be a value investor during market declines…or whether I merely label myself as such.
Knowing yourself when it comes to this question will have profound effects on the ultimate investment returns you experience in life because if you believe that your ability to handle fluctuations exceeds what it really is, then you will sell at the moment of maximum pain and receive terrible long-term returns resulting from the decision to realize steep paper losses.
Those are my thoughts on the bond questions raised by Bogle’s prediction. The other premise worthy of discussion from Bogle’s prediction: Must investors be doomed to 4% annual returns over the next decade from the stock-based investment returns, or is there a way to do better than that?
Bogle starts the engineering process for us, breaking down our total returns over the next decade (or any investment period for that matter) into three pieces. There is the dividend component, which Bogle assumes will be 2%. There is the earnings growth component, which Bogle pegs at 5%. And there are the changes in valuation of each individual stock, which Bogle assumes will take 3% off of long-term returns.
There are over 15,000 publicly traded stocks that you can purchase with a click of a mouse. You only need to find a dozen or so over the next decade that have a superior probability of offering better likelihoods than the 2%, 5%, -3% projections that Bogle offers. The easiest hurdle, I think, is finding investments that don’t come with that -3% valuation compression attached.
Exxon currently trades at $85 per share. It’s delivered 14% annual returns (or better) during each commodities bear market in which investors purchased the stock after a 40% or greater decline in the price of oil. The only exception to that rule is the investors that bought Exxon during the 2008-2009 crash, as commodity prices are low again here in 2015, and a six-year compounding period has not been enough time for production growth and reinvested dividends to drive superior returns. Someone who bought Exxon in 2009 has only compounded at 7% through today, though I find that total impressive given that the barrel price of oil during the recession averaged a little over $50 per barrel (not far off from where we are now.)
Because Exxon is a cyclical, it evades the normal P/E analysis that we could easily do with something like Colgate-Palmolive. But it is more likely that Exxon’s valuation will expand over the next ten years as the cyclically adjusted P/E ratio of 9 right now is a bit below the 11 range that Exxon averages during normal operating environments like 2003, 2004, 2012, and 2013. By purchasing something like Exxon right now and holding through 2015, we have replaced the -3% valuation compression with a 2% valuation expansion. A five-point swing.
Regarding the dividend, Exxon now pays nearly 3.4% compared to the S&P 500 average of 2%. That gives us another 1.4% to count in our favor.
Then there is the question of earnings per share growth which Bogle predicts to be 4% for the typical S&P 500 company. In Exxon’s case, we have a company that grows total companywide revenues at 4% on average since the merger between Exxon and Mobil. But the 3.4% dividend yield right now is different than Exxon’s 4% and 5% yield in the 1970s and 1980s.
Why? Because Exxon changes its business model to account for stock buybacks. If you bought Exxon in the 1970s and 1980s, the dividend account for between 70% and 80% of profits. The buybacks were nearly nonexistent until the late 1980s. Now, even during this commodity market decline, the dividend payment only accounts for 40% of profits. The company has, on average since 1998, retired 3.5% of all common stock per year. This makes Exxon a company that delivers 7.5% earnings per share growth rather than 5% as predicted by Bogle.
In short, you get: 3.4% dividend, 7.5% earnings per share growth, and 2% from valuation expansion. That works out to nearly 13% annual returns. It sounds high, but then again, this is exactly the type of returns that Exxon has delivered coming out of bear markets throughout its corporate history. You don’t become a $350 billion company unless you have a basic compounding engine in place that is growing at a nice rate. Even if part of the predictions prove too optimistic—say earnings only grow at 5% and there is no valuation expansion over the long term, we are still talking about 8.4% returns.
Exxon hasn’t yielded 3.4% in the past 25 years (you could get it around 3% during the worst of 2009.) That makes me think valuation expansion is likely, given that the company produces 4 million barrels of oil per day and 25 billion barrels of reserves. Exxon has been replacing them at a rate of 123% per year over the last five years. That is much better than its competitors like BP and Shell, which have only replaced reserves at a 40% rate since the decline in prices (because those companies have halted just about everything to maintain the dividend.)
I don’t think Bogle’s prediction has to be your destiny. Maybe if you are in the wealth preservation stage some of Bogle’s bond predictions will likely come true and affect you personally, but the good news is that you are trying to preserve rather than build wealth so the consequences of Bogle’s prediction will have a minimal effect on your daily standard of living. For those that need stronger stock market returns than Bogle foresees, you should focus on finding companies that offer better patterns than the 2% dividend yield, 5% earnings growth, and -3% valuation compression that Bogle uses to characterize the typical S&P 500 stock. You need to find a dozen or so Exxons to secure a better fate for yourself.
You can find John Bogle’s interview here: Vanguard Founder John Bogle Projects ‘Nominal To Zero’ Real Returns Over The Next Decade.