Bogle’s dour view on stocks, bonds. What if he was right?

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Vanguard founder John Bogle surprised an audience with a dour forecast late last year. But what if he was right?

Bogleheads attending his annual conference in October were taken aback when Bogle predicted that stock and bonds returns would be significantly lower than historic benchmarks returns. Over the next decade, stocks will return an average of 4% annually while bonds will earn 3.5% annually, he forecast. Both predictions are significantly lower than historic returns since 1974 of 11.7% for stocks and 8% for bonds. (Editor's Note: John Bogle passed away Jan. 16, after this article was published.)

With a 2% inflation rate, Bogle pointed out that a half-stock and half-bond portfolio might be expected to return an inflation-adjusted rate of 1.75% annualized, before fees.

Before dismissing this forecast as being too conservative, consider this: First, there is Bogle’s track record of often being right. Second, those who have scoffed at Bogle’s folly in the past later copied his inventions to try and catch up with the $5 trillion Vanguard giant. It’s easier for me to dismiss Harry Dent’s stock predictions of surges and great depressions than Bogle’s predictions.

Bogle’s forecast on stocks is based on a 2% dividend yield plus 4% earnings growth offset by a negative 2% speculative return, or a change in the P/E ratio. His bond return forecast is based on current yields combined with accepting more credit risk than the U.S. Treasury bond.

This is not to say that you should bet the farm on this forecast. But consider seven implications, and possible changes, to what you might tell your clients.

1) Fees will become increasingly important as even a 1% total fee will take more than half of clients’ real returns. Clients may be a bit more forgiving with fees when returns are high, but they will be sure to grow more cost conscious when they see much of their real return being diverted. By concentrating on dirt low fees, you and your client are likely to win even if Bogle’s forecast turns out to be too conservative.

2) Safe spend rates aren’t. The 4% safe-spend rule has been dead for some time. My modeling shows spending 3.5% of one’s 50% stock portfolio, increasing annually with inflation, has a 90% chance of lasting only 25 years. I’ve also assumed a very low cost portfolio, with disciplined rebalancing in that modeling. When people point out that I’m too conservative, I note that my assumptions in the 2008 plunge barely made a two- standard deviation event, which should happen once every 20 years. I’ve assumed a 3% real return of a 50% stock portfolio, which suddenly makes me an optimist compared to Bogle’s 1.75% real return assumption.

Consider communicating lower safe-spend rates to your clients — even if it means they might have to work longer. I’d much rather later tell a client I was too conservative and they can now spend more money than tell them they are running out of money.

3) Pension plans and municipal bonds will be in big trouble. According to Moody’s, pensions ended fiscal year 2017 with $1.6 trillion of unfunded pension liabilities. But that’s assuming a 7.56% annualized return going forward, according to the National Association of State Retirement Administrators. While pensions have alternative assets other than stocks and bonds, there is no assurance they will perform better than stocks. They have not over the past several years. With my simple calculations, even if pensions earn a full equity return of the 4% forecasted by Bogle, that means unfunded pension liabilities will rise by nearly a trillion dollars because of the large compounding differential over a decade.

Nearly all baby boomers will have retired by then and the payouts would stress these pensions. That stress would likely impact the states’ and municipalities’ abilities to service the municipal bond debt they have issued. While this is far from a certainty, consider limiting municipal bonds in your clients’ portfolios. I’ve set a limit of no more than 20% of the client’s fixed income and may even lower that limit. Limiting your clients’ exposure to munis may also be appropriate.

4) Insurance companies could be stressed. The good news is that insurance companies generally have their portfolios mostly in investment grade bonds, as required by the state insurance regulators. I suspect they have been less aggressive in their assumptions. Still, some products such as whole life could be stressed. Other products like variable life and fixed-indexed annuities (formerly known as equity-indexed annuities) could be vehicles that bail out the insurance companies since they typically allow the insurers to either increase premiums or decrease the return that flows to your clients.
While I’ve never been a fan of investing through insurance companies, Bogle’s forecast may offer another reason to limit those products for your clients.

5) Money will flow from stock funds to bond funds. Since 1900, stocks have outpaced bonds by 4.2 percentage points annually, according to Bogle’s presentation. Now he projects that differential to be only about 0.5 percentage point. If the volatility of stocks stays many times that of high-quality bonds, then it is reasonable to assume investors will flee risky stock funds to get a nearly identical return on bond funds. That itself can create the self-fulfilling prophecy that results in lower stock returns.
Consider a more conservative allocation for your clients now, especially if they don’t have the need to take risk. Don’t do what many advisors did after the 2008 plunge, which was to grow more conservative. While I can’t predict markets, I suspect that investors will remain predictably irrational and sell their stock funds after a bear market.

6) International stocks may do better. Valuations are less rich in international stocks. Thus, the minus 2% speculative return might not apply to non-US stock markets. Perhaps they will outperform US stocks as they did between 2002 and 2007. Bogle isn’t a fan of owning international stocks and it seems he’s been right over the past decade.

That said, I’m sticking with my recommendation that clients have a third of their equity in international stocks. If they do outpace US stocks, I’ll rebalance. You should decide on a percentage of international to domestic for your clients and stick with it.

7) There will be a global economic downturn. Here I am ending on a doom and gloom note. If Bogle is right, that will likely lead to a bad recession, along with a mushroomed US deficit and debt. It’s not impossible that Harry Dent’s predictions of a new great depression ahead may finally come true. Such a scenario would likely be good for bonds and bad for stocks. The implications also point to a higher allocation to the highest quality bonds. If US government bonds default, our portfolios would become irrelevant.

The beauty of the seven suggested changes above is that they have less downside risk and more upside potential than not making changes, and may help your clients enjoy the money they have worked so hard to build.

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