Morningstar Advisor - February/March 2010 - 49

I believe we’re going into a slow-growth U-shaped recovery, but I think we can still get a reasonable rate of return from stocks, because the price was driven down to a point that makes the future returns reasonable. Gus Sauter on average, the equity risk premium is at historic norms all the time. So, I think that we’re looking at average rates of return going forward, and that’s based on the concept that we’re rewarded for investing in stocks because of the risk inherent of investing in stocks. If we weren’t going to be rewarded for that, we’d sell stocks, and we’d sell them down to a price that made them attractive again. In fact, that’s what happened from the end of 2007 to the beginning of 2009. I believe we’re going into a slow-growth U-shaped recovery, but I think we can still get a reasonable rate of return from stocks, because the price was driven down to a point that makes the future returns reasonable. So, we are at a policy benchmark weight in equities in our Managed Payout Funds, thinking that we’ll get historical rates of return over the intermediate to longer term. RL: Are you saying that the other asset classes in the funds are at some type of reasonable valuation range, including long-term Treasuries and TIPS? GS: If there’s a bubble, it is in Treasuries. There RL: John, what is your thinking? JH: On the stock side, our view as of the present, which is about 1,041 on the S&P 500, is that the S&P 500 is priced to deliver total return over the next decade somewhere in the region of 6.5%. The way that we get our longer-term projections of total returns on stocks is fairly straightforward. If you look at S&P 500 earnings over the long run, you’ll find that they have historically behaved in a very well-defined growth channel of just over 6% annually. You can draw that on logarithmic paper as far back as you care to look. Then you look at where earnings are, anticipate that over the next decade you’ll get to about midchannel earnings, and then apply a historically reasonable range of P/E ratios to those terminal earnings, anywhere between the extreme low of seven, which is what we saw in 1974 and 1982, to a multiple of 20, which is where most historical bull markets have run into a great deal of trouble. You look at about the midrange of those estimates, and you’re at about 6.5% long-term returns. In terms of the bond markets, we have cross currents there, because I am convinced that the enormous amount of issuance in government liabilities that we’ve seen over the past year, and anticipate seeing for some time, will eventually be accompanied by a reduction in the willingness to hold those assets. But that reduction in willingness is likely only to occur after we’ve seen some amount of stabilization in credit conditions. Our view is that credit conditions are still deteriorating, and we’re about to get a second wave of mortgage defaults based on the reset schedule that’s been in place for years. Near term, we’re not likely to observe sustained upward pressure on bond yields. In fact, we may get additional flights to safety like we saw in 2008. But over a longer horizon beyond the next four to five years, that’s when we’re likely to observe more difficulty with inflation. GS: We’ve got to have a $10 bet. The difference between your 6.5% return on equities versus my 10%. I say it’s going to be greater than 8.25% 10 years from now; you say less than 8.25%. JH: If we mark those expectations against 1,041.52, which is where the S&P is as we speak, you have a bet. Rather than $10, let’s wager lunch. GS: All right. JH: And Gus, I really enjoyed this. I hope you don’t take any of my disagreements personally. GS: Nor mine with you. K Ryan Leggio is a mutual fund analyst with Morningstar. has been a tremendous flight to quality, and having taken on credit over the past year was a good investment move. There’s still some advantage to taking credit risk above and beyond Treasuries. We do think that the spreads between Treasuries and credit will continue to narrow, but they will by Treasuries backing up—not in the next month or three months, but over the next year or two. MorningstarAdvisor.com 49
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Morningstar Advisor - February/March 2010

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