Reprinted courtesy of the National Post
by Tom Bradley

I find this part of the market cycle to be the most difficult. I’m referring to the fact that a nine-year bull run has pushed client expectations higher, and yet, opportunities to generate future returns are lower. And layered on top is a general complacency around risk.

To be clear, I don’t know exactly where we are in the market cycle. Nobody does. The good times could continue for years, but if I were to use the baseball analogy, it feels like we’re in the late innings. I say that because 9 years is a long stretch and there are many late-cycle signs.

Interest rates are rising and the yield curve is flattening (yields on short-term bonds are now similar to long-term bonds). Examples of excess abound, whether it be tech and cannabis takeovers at stupendous valuations, elevated acquisition activity of other public and private companies, or looser lending standards in the junk bond market. And for me, it’s late cycle when value stocks look like they’ll never outperform growth stocks again.

Does it matter what inning we’re in? Investors with a multi-decade time frame shouldn’t change their strategy anyway. They should plow as much money as they can into their portfolio and let it compound over time.

But it’s still important to know roughly where you are in the cycle because realistic return expectations lead to better investment decisions and ultimately better investor behavior. Let me explain using our current situation.

Lower returns going forward

While I can’t time the market, I can confidently say that investors will achieve lower returns over the next five years than they did in the last five. There are a number of reasons for my confidence.

First, the secure, predictable part of your portfolio isn’t going to earn much. Near-zero interest rates in Canada mean that fixed-income returns are going to be low single digit. A reliable predictor of future returns is the current yield and today, the overall bond market is yielding just under 3%. Safety is expensive.

As for stocks, valuations have improved in recent months due to higher profits and choppier markets. Price-to-earning multiples are back to the mid-to-high teens (depending on what index you look at), which is near historical averages. But looking at P/E’s alone can be deceptive.

You also need to consider where the companies are in their profit cycle.

In this regard, I think we’ll look back in a few years and marvel at how good things were from 2014 to 2018. Everything was clicking. There was broad-based economic growth. Wage growth was modest. Credit was cheap and plentiful, leading to a boom in share buybacks and acquisition activity. And rising debt levels were not a concern.

Profits can go higher and multiples may expand back to where they were in January, but suffice to say, paying slightly high multiples for extremely high profits is a bad combination. It points to lower future returns for stocks. We’re currently suggesting to clients that a reasonable expectation for index returns over the next five years is between 4% and 6% per year.

Taking what the market has to offer

Whether you are managing your own portfolio or working with an advisor or portfolio manager, recognize that the set of factors that produced your past returns have changed, and not for the better. The most important determinant of future returns is the conditions at the starting point.

Going forward, home runs will be rarer and come with more strike outs. Indeed, it will be a struggle to get on base at times, so you should be happy with a single, walk or even a “hit by a pitch.” You’re going to be grinding it out for a while.

In the years to come, if you’re not getting the same returns you’re used to, don’t change strategies or increase your risk level without first reviewing how the markets have been doing. You may need to make changes, but your disappointment may also be because the opportunities aren’t there.

Successfully managing your portfolio over a full cycle means taking what the market gives you. Swinging for the fences when the pitches are in the middle of the plate and taking a walk when there’s nothing to hit.