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US equities are priced for near zero returns out to 2034

Since the bottom of the crash 10 years ago, the S&P 500 has appreciated by a compound average of 15% per year, one of the strongest runs in history.

S&P 500 Real Total Returns (after inflation, including dividends)


Short-term market predictions are a fool’s errand, but we aren’t investing for the short-term. When we filter out headline commentary and focus on the actual drivers of market returns, we can develop sufficient confidence to make portfolio allocation decisions. The underlying mechanics and historic data make it clear that present valuations determine future returns.

Stock Returns = Dividends + Earnings Growth + Change in PE Ratio

Stock market returns come from dividends, earnings growth, and changes in the earnings multiple. That is all. There is no mystery about this equation. If investors in the future are willing to pay the same multiple as today, dividends are steady at 2%, and earnings grow at 4% per year, the return to holding stocks will be 6%. 6% is roughly the long-term compound return on US and foreign equities over the last century, after inflation. That’s a doubling of purchasing power about every 12 years.

The trouble of course is that even if you hold stocks for 15 years, your net rate of return can be anywhere from -3% (or worse) to +15%.  The vast majority of that variation comes not from changes in dividends and earnings growth, but changes in our collective assessment of the future, as expressed in the earnings multiple. Multiples are not derived through a rational process, because if they were they would not be so volatile. Equity indices are simply a perpetuity (a never-ending stream of cash flows), which is not terribly difficult to value, even given some variation in future cash flows. By thinking of equities in this way, we can coolly assess the price on offer and the prospects for future returns.

Towards a better assessment of fundamentals

Quarterly fluctuations in earnings dominate the headlines, but we should be more concerned with the earnings to come over our entire investing future. Earnings vary with margins and the economic cycle, but they have always reverted towards a long-term trendline of roughly 2.5% real growth (total returns averaged 6% because dividends have previously been higher than today’s 2%). Earnings growth has been as high as 5% during generational booms, but has also been slightly negative for long stretches.
S&P 500 Earnings per Share (2018 dollars)
10-Year Running Average

Earnings are currently around $135 per share of the S&P 500, which translates to a multiple of about 20 when divided into the current S&P price of 2800. The trouble of course is that current earnings might be $180 or $45 next year, and it would be absurd to say that the true value of the market should then be a third higher or two thirds lower at that time.

Volatile variables can be made more useful with a running average, and in this case we see that the 10-year average is $97. Even this has its ups and downs, but it provides an adequate tare against which we can weigh prices. Divided into 2800, this gives us a multiple of 29, which figure is known as the cyclically-adjusted price-to-earnings ratio (CAPE or Shiller PE). For example, Shiller earnings at the last peak in 2007 were roughly $70, and in the depths of the recession they contracted only 10% to $63.

Below we chart the CAPE over the last century versus the actual subsequent returns of the S&P 500 from each date. So, when looking at the mid-1960s we can see that the CAPE was about 23, and that investors who held the market until 1980 achieved approximately zero net returns over that period. By then, however, the CAPE had contracted to roughly 10, and returns from there to the mid-1990s were correspondingly high. We can also clearly see the bubbles of the 1920s and 1990s and the poor forward returns from those points in time.

CAPE of S&P 500
Subsequent 15-year real return rate (%)

The price multiple has expanded from 12 to 29 over the last decade, a growth rate of 9%. When we add in the 4% annualized growth of Shiller earnings (from $63 to $97) and a dividend of 2%, we arrive at our real total return of 15%. Unless investors continue to pay 9% more every year for each dollar of earnings (such that by 2028 they pay $70 for $1), 15% is an unsustainable rate of return. There is no upper bound to the madness of crowds, but such enthusiasm has always eventually waned. Also keep in mind that the global average CAPE is roughly 20 today, despite the fact that long-term returns to foreign stocks are roughly equivalent to US stocks. There is no historical US valuation premium, and the US sometime trades at a discount, as it did in 2005-7. When other markets are priced to deliver solid 4-5% real returns, this is a good time to examine whether your portfolio shows home country bias.

Earnings and dividends are real, multiple growth is ephemeral

Reasonable investors look to actual, sustainable cash flows as a touchstone, because over the history of the world’s stock markets the real long-term rate of return has ranged from 4-7%, as delivered by earnings growth and dividends. Anything in excess of that is a temporary consequence of the crowd paying more for each dollar generated by the underlying businesses. Long stretches of high returns must be followed by low or negative returns to bring the indices back to their sustainable long-term trendlines. For the S&P to return to the mid-range of historical valuation right now would require a decline of 40% or more (taking today’s historically high profit margins into account, this might be 60%), but if multiples come down over time, earnings growth and dividends can catch up to prices. All of this leads us to conclude that the investor who holds US equities for the next decade or so is very likely to see a net real return of -1% to +2%, unless multiples happen to again be highly elevated at that time (the 3.7% real return from 2000 to today was higher than expected because multiples happen to be high today). That bet is hardly worth the very likely risk of deep losses in the interim, should multiples revert faster.

This is mere commentary when it comes to momentum-based tactical asset allocation, because the US stock market is only a fraction of the potential investment universe. That said, now would be a good time to examine any other accounts, such as 401(k)s, that may by default be heavily exposed to US equities. Even without access to ETFs, one can assemble a balanced portfolio of quality bonds and international stocks that is likely to deliver better returns over the coming years than the crowd’s favorite asset class.

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