Capital Market Expectations:
Outlook for Third Quarter of 2005

graphic depiction of a 3rd quarter

By Adam Jared Apt

LTSave bases its portfolio advice on long-term expectations for the financial markets, not on what it might expect over short periods, like the coming month, or quarter, or even year. Most of LTSave's customers are investing for longer periods. Even when the customer is just one or two years from retirement, the best starting point for developing an outlook for the portfolio is still the long-term perspective.

Having made that cautious introduction, we should add that long-term outlooks do change over time, as the markets go up and down, shifting our vantage points. New information also comes in, as well as new ways of thinking about the long term. LTSave revisits its forecasts every quarter, but they don't change very much.

LTSave's view is that the stock market returns that we recall from the 1980s and 1990s are not going to be repeated in the next couple of decades, which is about as far ahead as we can look. Those returns in the past were unusually high, though not quite so unusually when you look back over the 20th century. But even that century was unusual. The 1980s and 1990s were more representative of the second half of the century than of the first.

We've been saying for some time that, as we look forward, we see stock market returns that are maybe a little greater than 7% per year. Does this sound low? Some, who recall the end of the last century, may think so, but others, who are thinking of the last five years, may not. We'd like to reassure our readers that we're not radically different from quite a few analysts who have thought about this problem very deeply. Indeed, we find ourselves reassured when we see that analysts whom we admire are coming to roughly the same conclusion as we.

It's a little harder to come to grips with bonds. For some time, at least until earlier this year, most analysts felt that long-term yields were unusually low, and even Alan Greenspan said that this was a "conundrum." Lately, however, analysts from across the political spectrum -- and politics does seem to affect the way a person sees interest rates -- have presented cogent arguments that bond yields will remain low for some time. One prominent economist has even said that he expects them to go lower. LTSave is being a bit more cautious, and is working with a long-term outlook of 4.6% per year for the ten-year U.S. government bonds, which is a bit above the current yield of 4.18%.

Our outlook for inflation isn't much different from its historical average, and we're assuming that it will continue at around 2.5% per year. That's only a little above the forecast of the Congressional Budget Office, which sees inflation averaging around 2.2%. (The numbers that we gave above include inflation; if you want to know what we think stocks and bonds will do after adjusting for inflation, just subtract 2.5%.)

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