Stocks closer to fair value
Based on the guidance the Fed has provided regarding rates’ likely path, we can reasonably project the performance trajectory of fixed income, if not necessarily its exact timing. Projections for stocks are tougher to do, but there is room for cautious optimism over the medium term. At the beginning of the Fed’s hiking cycle, the U.S. stock market was overvalued: The Shiller price-earnings ratio for the S&P 500 Index at year-end 2021 was more than 30% above our estimate of the S&P 500’s fair value. This year’s downturn means we’re now more in line with the long-term average.
Those hoping for a V-shaped rebound, where stock prices bounce back as sharply as they fell—like in early 2009 or, more recently, March 2020—may be disappointed. In certain ways, we’re closer to the market conditions of 1999–2000, when stocks were overvalued and the subsequent plunge only brought valuations closer to long-term averages. After the dotcom bubble burst, returns eventually normalized, but there was no market bounce.
The market’s current lower valuations have the upside of increased expected returns. Our models project 10-year annualized returns that are almost 2 percentage points higher than a year ago for both U.S. and non-U.S. stocks, though still below long-term historical averages.
The recent strengthening of the U.S. dollar—driven by the Fed’s aggressive rate hikes relative to other central banks, on top of the natural flight to U.S. Treasuries during times of global crisis—means that returns for non-U.S. investments will be muted over the short term relative to U.S. investments. Long term, however, we expect these two drivers of the U.S. dollar strength to reverse, which would help non-U.S. stocks.
Overall, with improved outlooks for fixed income and stock markets, return expectations for a balanced portfolio are gradually normalizing back to historical averages. For most investors, staying balanced and diversified across asset classes and borders remains a prudent course.
