Semiannual Report

A model portfolio for a moderate growth investor may have approximately 60% in stocks and 40% in bonds.  According to Vanguard, the average return for this model from 1926-2015 was 8.7%*.

In my opinion, the majority of investors with a middle of the road risk tolerance would be satisfied with that return.

If one thinks of the current environment as one that resembles the average of 1926-2015, he/she can follow that portfolio model and expect similar returns. However, if the current environment does not resemble the past, should one invest differently?  My answer to this is a resounding “Yes”.

Based on low interest rates and high stock valuations, investors will find it challenging to mirror the returns from 1926-2015 if investing in a 60% stock 40% bond portfolio.  Many should strongly consider altering their investment allocation and adding a meaningful weighting to Alternative Investments.


Why are interest rates so low?

The Federal Reserve’s goals are to maintain price stability (controlling inflation) and maximize employment.  It usually controls the Federal Funds Rate (the interest rate at which banks lend to one another) by buying and selling short term Treasury bills (“Treasuries”).  When the Fed wants to stimulate the economy, it injects money into the economy by purchasing short term government bonds, which lowers interest rates and incentivizes people and companies to borrow.  If the economy is strong, and inflation is well above the Federal Reserve’s target, the Fed may elect to sell Treasuries.  The intent is to remove money from the banking system, which will raise interest rates.

In November, 2008, the economy was in the midst of “The Great Recession.” (According to the U.S. National Bureau of Economic Research, this began in December 2007, and ended June 2009).  The Federal Funds Rate was at a range between 0% and .25%. With the intention of stimulating the economy, the Federal Reserve embarked on a program known as “Quantitative Easing (‘QE’)”.   This is the process of buying other securities outside of short term Treasuries, such as Mortgage Backed Securities.  The goal is to inject liquidity into the banking system with the hope that banks will lend that money to businesses.  This process also pushes down interest rates and therefore banks are more incentivized to lend money to people and businesses, instead of buying Treasuries.  For an explanation on how “QE” works, this person does a pretty good job of explaining.

Another byproduct of lower interest rates is generating the “Wealth Effect”.  By pushing down interest rates, investors are more inclined to invest in assets that have the ability to produce income or growth, such as stocks.  If one believes in the Wealth Effect, when investors see their portfolios grow, they are more likely to spend money which spurs growth and increases company’s profits.  This may lead to a cycle of stocks increasing > people spend more money > company profits increase > stocks increase (repeat).


Where are we now?

One of the reasons I am skeptical of a 60%/40% portfolio generating a high single digit return is because the fixed income portion is highly unlikely to generate as strong returns as in the past.  The Ten Year Treasury yield is the return you will receive if loaning money to the Government.  The average yield since the 19th century is 4.58% (  Today (June 6, 2017), the Ten Year Treasury yields 2.18%.

In order to capture the historical return of 8.7%, equities will have to generate a return above what they historically have so as to overcome the lower return bonds may offer. According to Vanguard, a 100% equity index generated a 10.1% average return.

Let’s look at how likely it is that the S&P 500 will generate the historical long-term average of 10.1%.  In the book The Intelligent Investor, Benjamin Graham (Warren Buffet’s mentor), stated that overall stock market returns are generally based on several factors.  1) Dividends, 2) Real Earnings Growth, and 3) Price/Earnings Multiple Expansion (Investor’s appetite for risk), and 4) Inflation.  These factors are to be added, which he believed provides a simplified equation that approximately measures stock market returns.

The average dividend yield on the S&P 500 index is below 2% ( (1.91% to be exact) and the average dividend yield since the 19th century is 4.38%.

According to economist Robert Shiller (, earnings per share on the S&P 500 grew at a real rate (inflation adjusted) of 1.7% between 1874-2004.  In the last several years Earnings haven’t grown much at all.  In 2011 $94.21 and 2016 $95.76.

The current price/earnings ratio is over 25, and the average is 15.66.

Year over Year inflation is 2.38% ( and the Federal Reserve targets 2%.

Based on a 1.91% dividend yield, earnings growing on average of 1.7%, and 2.38% current inflation, the total stock market long term return is 5.99% based on Graham’s methodology.  In my opinion, that’s fairly typical of what to expect the long-term return of stocks to offer when dividends and growth are below historical standards. As of today, the past 10 year average return for the S&P 500 is 6.13% (reference my weekly economic update e-mail sent Monday, June 12th).

It should be noted that an investor’s appetite for risk can be a significant factor that drives returns.  For example, from 2011-2016, earnings have been flat but S&P total returns are up approximately 77% (  This has largely occurred because the P/E multiple expanded from 16.30 in 2011 to 24.06 in January 2017.  Investors’ appetite for stocks increased.

Typically, increased P/E multiples can act as a tailwind (pushing stocks higher) or headwind (pulling stocks lower). When the multiples are above the average (as is true today), I would consider that to be a headwind in the long term.  I don’t think you can expect the P/E multiples to continue to increase at the rapid pace they have in recent years. It’s certainly possible that the P/E multiples will continue to expand, but in the long run, I think they will act more as a headwind as numbers usually revert to their averages. Unless you believe that “this time is different”!  If this time is really different, and P/E multiples stay at elevated levels for extended periods, stock returns may be higher than some are anticipating.  I think reversion to the mean will prevail, and that the multiples will eventually revert closer to the long-term average.  (If this topic is of interest to you, I recommend reading Jeremy Grantham’s quarterly letter, (

Back to the 60%/40% portfolio.  Let’s assume the bond portion is blended with other fixed income securities that are riskier than treasuries (e.g. corporates, high yields) and assume you can attempt to capture a 4.5% return instead of only 2.18%.  What would equities have to grow at in order to obtain the 8.7% total return for a 60% stock/40% bond portfolio?

(60% bond weighting) (4.5% bond return) + (40% equity weighting) (X equity return) = 8.7%.  Solve for X.

In order to generate the historical average 8.7% return, equities would have to return 15%.  This is above the 10.1% historical stock return, and well above Benjamin Graham’s simplified long-term market return calculation of 6%.

Based on high p/e multiples, and a low dividend yield, you can see why I am skeptical of stocks returning an average of 15% annually.  This is why you have heard many experts predict that at current valuations, investors may have to settle for lower long-term returns.  This includes Jack Bogle (Founder of Vanguard), who is predicting 4% total returns on stocks based on where markets are currently valued**.  He arrives at this figure using a similar methodology as Benjamin Graham.  He thinks P/E multiples will decline, thereby subtracting from overall returns.


What not to do

Cash and cash equivalents is a very poor long- term investment strategy.  This is because if inflation is over 2%, and cash equivalents are paying 1% interest (many are still paying less than 1%), you are actually losing 1%.  I refer to this as “safely losing money”.  It is prudent to maintain between 3-9 months of living expenses in cash or cash equivalents, and if you intend to make a big purchase item (vacation home, car), cash is an appropriate investment vehicle.  However, as a long- term investment, cash won’t outpace inflation as stocks and bonds have historically done.

If you’re waiting for the “perfect time” to invest, my advice would be DON’T!  I stated the following in an article I previously published, “Dollar Cost Averaging”:

“Timing the market and waiting for the perfect time to invest is a fool’s game because nobody knows when the perfect moment will come. What I’ve seen happen regularly to those who wait for a perfect moment to invest are the following: 1) The investor waits for the market to decline and tells himself he will buy when that happens; 2) When the market declines, the investor doesn’t buy anything because it’s declining and, of course, will fall further; and 3) The market increases and the investor can’t buy because the market is increasing and it’s too late to buy.

What happens is that the investor does nothing. He sits on cash and lets inflation eat away his principal, so his dollar will be worth less in the future. He is “safely losing money”.

A strategy that should be considered to manage risk is Dollar Cost Averaging. This occurs when a person decides to invest a certain dollar amount over a period of time systematically. His decision to buy is not based on factors such as how the economy is doing, or the performance of a particular stock. The advantage of this approach is that it removes emotion from the equation.”

Not being diversified.  Concentrated bets on stocks or sectors are dangerous.  It may appear that a certain stock can do no wrong and can only increase.  However, that is not the case.  A good company doesn’t necessarily mean that its stock is good to own. Make sure you’re diversified among stocks (small/mid/large, growth and value) and sectors. Same goes for bonds. Ensure you hold conservative bonds (Treasuries), but also fixed income that can provide higher yield (corporates, floating rate debt).

I’ve recently heard some analysts recommend selling or underweighting bonds, and overweighting stocks. Their reasoning is that equities may be overvalued, but despite this, bonds yields are low enough that an investor should reach for a higher return and overweight equities. I disagree with this statement, and outline below what I feel is the most appropriate strategy.


What I believe is perhaps the best strategy moving forward for certain investors

Because of low bond yields and high stock valuations, it is my belief we are in an environment that calls for a meaningful allocation towards Alternative Investments.  I define an Alternative Investment as an asset or strategy that has low correlation to stocks.  When one asset tends to move up when the another goes down, the two assets are considered to have a low or negative correlation.  Therefore, there’s a possibility these types of investments can provide positive returns if stocks decline.  It should also be noted, Alternatives may provide negative returns if stocks increase.

For compliance reasons, I won’t document many Alternative Investments, but I will provide an example:

Gold- The reasons for owning Gold are numerous and sometimes controversial. Some may own gold because they think inflation will increase and gold can maintain its value better than a currency.  Others may own gold because they view it as a “risk off” investment, which means that if stocks are being sold and investors are acting in a risk averse manner, capital may gravitate towards gold.

Eventually, interest rates may increase or valuations may fall back to historical averages (perhaps both will happen). When this occurs, the traditional 60%/40% portfolio may generate high enough returns to meet investors’ expectations.  I currently advise that rather than investing in the traditional 60% stock/40% bond portfolio, that one should strongly consider a 50% stock/30% bond/20% Alternative model.


Philip B. Snyder, CFA

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
Stock and mutual fund investing involves risk including loss of principal.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
Examples are hypothetical and not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
      When determining which index to use and for what period, we selected the index that we deemed to be a fair representation of the characteristics of the referenced market, given the information currently available. For U.S. stock market returns, we use the Standard & Poor’s 90 from 1926 through March 3, 1957, the Standard & Poor’s 500 Index from March 4, 1957 through 1974, the Wilshire 5000 Index from 1975 through April 22, 2005, the MSCI US Broad Market Index from April 23, 2005 through June 2, 2013, and the CRSP US Total Market Index thereafter.
      For U.S. bond market returns, we use the Standard & Poor’s High Grade Corporate Index from 1926 through 1968, the Citigroup High Grade Index from 1969 through 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975, the Barclays U.S. Aggregate Bond Index from 1976 through 2009, and the Spliced Barclays U.S. Aggregate Float Adjusted Bond Index thereafter.
      For U.S. short-term reserve returns, we used the Ibbotson 1-Month Treasury Bill Index from 1926 through 1977 and the Citigroup 3-Month Treasury Bill Index thereafter.