John Bogle, the founder of Vanguard and father of index investing, has long been using the following formula to estimate future 10-year stock market returns:
Total Future Returns = Dividend Yield + Earnings Growth +/- Annualized change in P/E Ratio
As described in his book, Don’t Count on It, this is an elegant approach, encapsulating every possible source of return. Let’s see how things look for those who will hold the S&P between now and 2028, using data from the always handy multpl.com.
S&P 500 dividend yield: 1.9%
Dividends have been very low in recent years due to high stock prices and an increasing tendency to use profits for share buybacks, which result in no tax liability for investors. This doesn’t result in a net change to our equation though, because buybacks reduce shares outstanding and thus bring down PE, all else equal.
Real S&P 500 earnings (2018 dollars)
To estimate earnings growth over the next 10 years, let’s just use the last 20 and say things won’t change. Real earnings have grown by an average of 3.03% since 2017, and when we add back 2.3% inflation, nominal earnings growth has averaged 5.35%.
S&P 500 PE (Shiller): 30.7
What the PE ratio will be in 2028 is anyone’s guess, since the numerator, stock prices, is so volatile. That said, we can eyeball the an average from modern times and say that our number will be 20 a decade from now, an annualized headwind of -4.2%. If multiples stay very rich, call it a wash at 0%, but if they contract into the teens as we are seeing in much of Europe today, call it -5% per year.
Let’s plug in the figures:
Total Future Returns = Dividend Yield + Earnings Growth +/- annualized change in P/E Ratio
Total Future Returns = 1.9% + 5.35% – 4.2%
= 3.05% before inflation
Back out inflation of 2%, and we are looking at total real stock returns of 1% for the US over the next decade. This expected return happens to be exactly what is on offer in the Treasury market right now, with the 10-year T-note yielding 3% nominal (1% real). The difference of course is that with Treasuries you are guaranteed that return, and likely to see far less volatility along the way.
In conclusion, US stocks today are a very poor bet for the buy-and-hold investor. Far better values are on offer overseas, where even developed countries like the UK and Singapore are priced for 6-9% nominal returns. It’s worth mentioning that even value funds are likely to have a bad time, as every segment of the US market is expensive (unlike in 2000, when the averages were pulled up by an outrageously overpriced tech sector but boring stocks like Berkshire Hathaway were cheap).
There is never a bad time to implement a globally diversified portfolio, but today would be a very good time to do so. Remember that a truly diversified portfolio does not rely only on equities, even equities from around the world, but includes generous allocations to REITs, bonds, and commodities. This is because if and when the US market corrects to more reasonable valuations, we can expect foreign markets to follow suit. That said, a risk-controlled global portfolio has very little correlation with equities in general, and can deliver good returns even when equities are out of favor, as many such portfolios did in years like 2001 and 2008.
Don’t wait to take a look at your current allocations, and get in touch if you would like to learn how you might be better prepared for the next decade, whatever comes to pass.