Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

There's an amazing amount of denial going on right now.

Investors are simply ignoring current market dynamics and are still expecting average annual returns of 8.6 percent, according to a Legg Mason Inc. survey of income investors released this week. Those who were employed expected more than 9 percent gains, with retirees expecting less. Actual returns have come in markedly lower of late, but hopes remain high.

Less and Less
U.S. junk bonds are yielding less than they used to in a world awash in central-bank liquidity
Source: Bloomberg Barclays indexes

This is wishful thinking at best and dangerous at worst. Today's stock and bond markets are profoundly different from those in decades past. Bond yields are near all-time lows. Stocks aren't paying that much relative to history in terms of earnings yield. Yes, prices could continue to rise, but that's becoming less certain as central bankers seek to tighten monetary policies and valuations get increasingly squeezed.

Stock-Yield Drop
The earnings yield on the S&P 500 has fallen below historical averages in this low-rate era
Source: Bloomberg

This new dynamic is no secret to anyone who manages money professionally. It's alarming that the hundreds of investors surveyed by Legg Mason still have such unrealistic expectations. Alan McKnight, chief investment officer at Regions Wealth Management, said he had seen similarly over-optimistic expectations from nonprofessional investors he's spoken with. "People want to look on a historical basis as to what they should expect in the future," he said Friday on Bloomberg Radio.

Many tell McKnight they need 8 percent returns a year; he'll tell them about 7 percent is more possible over the next five to 10 years and only with more aggressive allocations to equities and emerging markets. About 5 percent is more likely. They'll often stick with their outlooks anyway.

Here's the problem: The only way to meet these lofty returns goals is to take much bigger risks than in the past, and to do so at a time when many are already accepting relatively little compensation for bigger gambles. For example, the earnings yield on the S&P 500 is just 4.6 percent, compared with nearly 6 percent over the past decade historically, while junk-bond yields are 5.6 percent compared with 8.3 percent historically.

Heading Down
U.S. benchmark borrowing costs have dropped in the wake of central-bank stimulus
Source: Bloomberg

So far, many analysts say the market isn't prone to a collapse because of a lack of leverage in financial markets. It's true that valuations are high. And many companies have been increasing their debt relative to income. But this isn't generally the type of leverage that will automatically sink markets in a fast, broad-based manner.

That said, if investors cling to these inflated visions of future returns, problems will ensue. Unless people save more money and ratchet back their expectations, they'll likely end up seeking classic methods to juice gains -- namely, investing in funds that borrow short-term money to invest in longer-term assets.

It's important that investors are realistic. If they're not, fund managers will try to serve their hopes and dreams, making the financial system all the more fragile for it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net