NEPC, asset allocation consultant to the $110 billion Massachusetts Pension Reserves Investment Management board, raised its rolling 10-year forecast for U.S. stocks in February by a full percentage point to 5.7%, despite two consecutive years of 25% gains for benchmark indexes.
Such heady gains oftentimes create a headwind for future returns, but over the last few years NEPC has been “trying to make sure that our long-term assumptions for margins and valuations were not overly reliant on history,” Jennifer Appel, a principal and senior investment director with the Boston-based consultant, explained at a Feb. 11 investment committee meeting for the public pension fund.
That upward revision is the latest marker for an industry struggling to come to grips with “American exceptionalism” — a U.S. stock market where key metrics, from earnings growth to valuations, have continued to defy gravity over the past 15 years.
While Appel didn’t go as far as to say “this time is different,” she made it clear NEPC believes markets have evolved sufficiently to make slavish devotion to mean reversion untenable.
“Mean reversion can be a piece of the process but I think we have to acknowledge that the sector composition and … market dynamics today are different than they were in the past,” she said.
In response, PRIM has been gradually “phasing in some higher expectations for margin levels and valuations, and this time we decided to kind of pull forward some of the future adjustments we were planning on, to say that things are a little bit different today and we don’t expect to go back down to long-term averages for margins and valuations,” Appel said.
NEPC isn't alone in that regard.
Maria Garrahan, a senior investment officer and PRIM’s director of research, told the committee she’s seen “a significant bump up” in long-term return expectations for U.S. large-cap stocks from a number of different providers over the last couple of weeks — an interesting development “from a consensus standpoint,” she said.
Garrahan, in response to emailed queries, said “PRIM reviews forward-looking capital market assumptions from other consultants and investment managers to identify consensus trends.” She cited NEPC and Goldman Sachs Asset Management as two recent examples of providers reporting higher expected returns for U.S. equities.
If boosting 10-year forecasts for U.S. large-cap equities is indeed a trend, it remains a nascent one.
Of six other investment consultants Pensions & Investments spoke with for this story, only one, Santa Monica, Calif-based Angeles Investments, reported raising its 10-year forecast — for the broad universe of U.S. stocks — to 6.7% from 6.4%.
Angeles doesn’t break out a separate projection for large caps.
Executives at four of the other firms — while conceding that earnings growth, inflation, dividends and share buybacks can all enter into their calculus when hammering out long-term projections — said the latest surge in U.S. large-cap stock prices has weighed on their rolling 10-year forecasts.
Ten-year projections dipped to 7.25% from 7.50% for Callan LLC; 6.4% from 6.9% for Meketa Investment Group; 5.3% from 5.9% for Verus Advisory and 4.35% from 5% for Wilshire Advisors. Willis Towers Watson’s forecast held steady at 7.2%.
Arriving at those long-term forecasts is as much of an art as a science, executives noted.
David R. Brief, a partner at Angeles as well as head of OCIO, said a big part of his firm’s decision to boost its 10-year forecast by 30 basis points was the continued upward trend for U.S. corporate earnings.
If earnings, dividends and inflation were the sole criteria, to the exclusion of valuations, Angeles’ 10-year forecast would be closer to 8%, he said.
Lofty P/E ratios
While no law of nature proscribes that price-earnings ratios have to return to their historical range between 15 and 20 from today's lofty 25 to 30, PE ratios are likelier to go down from here than up, and “we essentially model 50% mean reversion, Brief said.
Some speculate that NEPC’s decision to boost its forecast by a full percentage point could simply reflect the fact that its prior-year projection of 4.7% was considerably below the 6.46% average tabulated in Horizon Actuarial Services’ annual tally of projections by roughly 40 consultants and money managers. Such a low forecast was potentially an uncomfortable starting point for conversations with clients about how to best meet their investment objectives.
Appel, in an email response to queries, said “equity return forecasts are based upon assumptions for real earnings growth with adjustments incorporated for profit margin changes, inflation, shareholder yield, and current valuations trending to long-term terminal value assumptions. For the December 31, 2024 assumptions, the terminal value assumptions for valuations, profit margins and shareholder yield were revised higher for U.S. Large Cap equity, which resulted in a relatively higher return expectation."
'Constantly' reviewing
If the direction of adjustments this year to long-term forecasts has been mixed, consultants are seemingly united in having to grapple with the implications of persistent, outsized U.S. equity gains.
The dominance of U.S. equity returns for some time now, relative to other equity markets, is “making us review our research and continue to challenge ourselves on how we’re building up these assumptions … constantly (reviewing) our prior thinking to confirm our comfort with our assumptions,” said Jon Pliner, head of delegated portfolio management, U.S., with Willis Towers Watson.
Frank E. Benham, director of research with Westwood, Mass.-based Meketa Investment Group, said those challenges are familiar to Meketa.
“We made similar changes to our models a few years back (to resolve the disconnect) between what we’re projecting and what’s actually happening” — looking for explanatory factors for the persistent strength of U.S. equities, such as a relatively sharp focus on shareholder capitalism or the role played by share buybacks, Benham said.
Like NEPC and Angeles, “our model assumes reversion toward the mean but not all the way back,” he said, adding that full reversion would have left Meketa’s 10-year rolling forecast closer to 5.5% than 6.5%.
That less-than-full reversion reflects higher expectations around earnings growth, which in turn could mean that U.S. equities would only require a 10% pullback to get to fair value as opposed to a 40% plunge, Benham said.
The change in the structure or composition of the U.S. market, with the rise of a handful of technology giants, has been another big factor helping to usher in this period of prolonged dominance for U.S. equities, with implications for the balance of costs and benefits clients are weighing in maintaining a well diversified portfolio.
The rise in U.S. equity valuations has “coincided with some structural change in the stock market and some advances in technology,” with practically all of the companies at the forefront of those advances here in the United States, said Jay V. Kloepfer, executive vice president and director of Callan’s capital markets research group.
That, in turn, has led to concentration, with the S&P 500 increasingly looking like a seven stock portfolio, Kloepfer said.
The seven stocks in question, known as the Magnificant Seven — Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla — have come to account for roughly 30% of the S&P 500.
"There's merit to acknowledging that the sector composition of the U.S. market has shifted and that we could expect, perhaps, a higher earnings growth rate in the future," justifying a review of capital market assumptions and methodologies, said Thomas Garrett, managing director, strategic research with Verus Advisory. Even so, valuations have become elevated for most U.S. market sectors — not only technology — and that should have a dampening effect on future returns, he said.
Persistent U.S. equity dominance, meanwhile, is testing the patience of investors who, while believing in the benefits of diversification, are being forced to defend the opportunity costs of diversification quarter after quarter.
Diversification's weak link
There’s accepting that there’s value in diversification, and there’s having the discipline to ride it out and stay with it when others are questioning it, noted Steve Foresti, senior adviser, investments with Wilshire.
Equities, Foresti said, have been the weak link in the diversification chain over the 10 to 15 years coming out of the global financial crisis, a period when rock bottom bond yields prompted considerable diversification on the fixed income side of a traditional 60% equity-40% bond portfolio.
“What we haven’t seen all that much of, other than by going into private equity, is what do you do with that equity piece,” with 70% of that 60% equity allocation in U.S. stocks, and U.S. stocks, in turn, completely dominated by a handful of names, he said.
“So, even what looks like a well-diversified portfolio, you start zooming in … and there’s super high concentration risk," with market movements effectively taking diversification away, Foresti said.
And maintaining a sense of humility when making asset allocation decisions could cut both ways, consultants say.
What can clients concerned about market concentration do, asked Callan’s Kloepfer. “You un-concentrate and buy cheaper stocks,” effectively saying you're smarter than the market and leaving yourself exposed to considerable “regret risk,” he said.
Meanwhile, Wilshire’s Foresti says, fundamental arguments can be made — on the strength, for example, of artificial intelligence payoffs or a newly business=friendly regulatory environment — for continued phenomenal growth for leading U.S. stocks.
While “not the argument I’m making,” it’s not, on its face, ridiculous or that controversial, he said.
Still, even if there are “a lot of reasons to be very optimistic about the fundamentals,” looking at what investors are paying for those fundamentals is reason for caution, Foresti said.
Meanwhile, if optimistic views either move investors into more concentrated portfolios or support the idea of hanging on to very highly concentrated portfolios, that will carry its own tail risks, he said.
“Technology tends to forever and always be disruptive, and when you’re in the middle of it, it’s hard to see how a dominant player is going to lose in the future ... but we’ve seen it happen time and time and time again,” Foresti said added.
Callan’s Kloepfer pointed to policy uncertainties now as an additional tail risk. Ejecting hundreds of thousands or even millions of immigrants at the same time as tariffs are being imposed widely could bring risks long banished from public consciousness, such as stagflation, back to the realm of possibility, he said.
