According to Vanguard, the 2014 outlook
for Global Equities will be in the 6% to 9% range. The median is moderately
below the historical average and revised downward from this time last year,
mainly because of current market valuations and their implications for the
equity risk premium. Vanguard’s outlook
is informed by valuation metrics (such as price/earnings ratios) that relate
accounting measures of value to the market’s aggregate price. Valuations today
are elevated in relation to both their lows in 2009 and their historical
averages.
Vanguard believes that valuations
will revert to a long-term average level and this reversion has been the
largest driver of the movement of long-term equity returns over time. This
supports their long-held view that valuations, not growth, are the most
significant drivers of returns. Therefore, valuations are the most useful
metric in estimating forward-looking expected returns of equity markets.
But what level will valuations
revert? Most valuation metrics have been above their long-term averages for
more than two decades, raising questions about the potential for structural
shifts. Without certainty as to where exactly valuations will move in the
future, it is very difficult to pin down a precise estimate of the equity risk
premium.
In short, although there is
evidence of froth in global equity markets it is hard to identify a bubble. The
uncertainty associated with forward-looking return estimates underscores the
fact that today’s valuation levels present a range of potential outcomes.
However, because the premium compensating increased equity risk appears to have
fallen recently, Vanguard is encouraging investors to exercise caution in
making strategic or tactical portfolio changes that increase this risk.
Specifically, Vanguard’s
valuation simulations indicate that the average annualized returns of a 60%
equity/40% bond portfolio for the decade ending 2023 are expected to center in
the 3.1% to 5.2% real return range, below the actual average real return of
5.5% for the same portfolio since 1926.
Click here to read the entire analysis from Vanguard.