Future Stock Market Returns

​(Revisiting my post from February 17th, 2020)
 
 
The market continues to be on a tear with the S&P 500 up 84% since the March low last year.  The problem with these aggressive short-term moves is we are pulling forward future returns.  Emotion tells us if returns have been great, they will be great in the future.  However, math tells us that after a period of above average returns, we will have a period of below average returns.  Before I make my case about future returns, let me be clear:
 
A)I am not predicting a date for a major correction.
B)I am not predicting the magnitude of the decline.
C)This has nothing to do with politics or my views on the economy. 
 
It’s just math.
 
The common questions are “Are we going to have a correction?”  “How bad will it be?”  “When will it happen?” “Should I be in the market or out?”  Unfortunately, nobody has the answers.  Market strategists are happy to answer these questions, not because they know, but because they are asked.  It’s difficult to justify a high salary if your answer is always “I have no idea”. 
 
In my opinion, the more appropriate way to think about markets is “can I expect to generate a good enough return over the long term (say 10 years) to compensate me for the risk I am taking?”  In March of 2009, stocks were cheap.  In fact, it was probably the buying opportunity of a lifetime.  At that time, I was projecting double digit returns for the long term.  It didn’t matter if you had a couple of awesome years followed by a couple of flat years.  The important thing was how the returns would average out over the next 10 years or more.
 
In the short-term, valuation is a lousy market timing tool.  However, in the long-run valuation makes all the difference. In March 2009, stocks were cheap with the S&P 500 trading at 666.  Although it was the buying opportunity of a lifetime, hardly anyone wanted to buy.  Funny how that works.  Today, the S&P is at xxx and stocks are expensive which means the math is not in your favor for the next 10 years.  Let’s look at the other times over the past 100 years when stocks were very expensive like they are today:
 
            Year:                                       Annual return over the next 10 Years:     
 
      1929 (Dow Jones)                                           -9.4%
      1999 (S&P 500)                                              -2.8%
      1999 (NASDAQ)                                              -7.3%
      2007 (S&P 500)                                              +5.2%
      2021 (S&P 500)                                                 ?
 
I like to break down the four components of equity returns to project what future returns are likely to be.  These components are:
 
1)Real GDP growth: 2.0%. The consensus is for above average growth in 2021 but a rate below 2% per year over the long term.  The FOMC (Federal Open Market Committee) has a long-term forecast of 1.8%.  For the past 12 years, growth has averaged around 2% per year so we will stay with that assumption.  With population growth at a fraction of a percent and productivity trending lower the past several years, it is difficult to generate much higher rates of growth.

2)Inflation: 2.4%.  This is what is currently priced into the fixed income market for the next 10 years.

3)Dividend Yield:  1.3%.  This is today’s yield on the S&P 500.

4)Change in Price/Earnings Ratio: -6.1%.  Today stocks are trading at 37.7 times normalized earnings vs. a long-term average of 16.8 times.  There has only been one time in history when stocks traded at a higher price to normalized earnings and that was during the tech bubble in 1999 prior to the NASDAQ falling 77%.  Although the long-term average price/earnings ratio is 16.8, I’m going to be optimistic and use 20 in this exercise given our low level of interest rates.
 
Add it all up and you get a projected annual return estimate of -0.4% for the next 10 years.  If price earnings multiples go back to the long-term average of 16.8, you are looking at an annual return of -2.1% over the next 10 years!  
 
Now you must ask yourself if you are willing to risk a significant decline to enjoy this annual return.  This will be a function of your age and risk tolerance, but I have found that young people don’t like losing money either.  When making this risk/return trade-off, consider whether or not earning a higher potential return will truly impact your quality-of-life vs. the life changing impact of having your retirement portfolio cut in half.
 
I understand the dilemma.  Terms such as “TINA” (There Is No Alternative), FOMO (Fear of Missing Out), YOLO (You Only Live Once) become very popular during bull markets along with talk of “never sell”.  You get attacked on social media for suggesting stocks are expensive or warning people against speculating with large portions of their portfolios. 
 
This is an incredibly challenging time to invest.  Cash is paying close to zero, high quality bonds are paying closing to zero, long term bonds & junk bonds provide some yield, but they have the added risk of losing money if interest rates climb. 
 
Personally, I think the TINA approach is a dangerous way to think about investing.  “I know stocks are significantly overvalued but I’ll buy them anyway because the alternatives are not good”.  Today’s thinking seems to be:
 
A) I can stay in cash or buy bonds and earn next to nothing or
B)Buy stocks because they have done well recently.
 
      I look at it this way:
 
A)I can preserve my capital/net worth, sleep well at night, and have plenty of dry powder to take advantage of future opportunities when prices are more attractive or
B)Risk losing xx-xx% of my capital/net worth. 
 
From the peak in October 2007 to the low in March 2009, stocks fell over 50%.  Moves of this magnitude are life changing.  Especially if you are close to retirement.
 
So, what are some other options to consider if you have decided you don’t want to be fully invested in the U.S. Stock Market:
 
1)You could raise cash levels.  It doesn’t have to be all of nothing.  In fact, we have never been 100% stocks or 100% cash.  We are talking about adjusting exposures based on risk and reward.  If you are young and stocks are cheap, you might decide to be 90% invested.  If you are young and stocks are expensive, you might be 60% invested.  If you are old and stocks are cheap, you might go with 75% exposure.  If you are old and stocks are expensive, you may want your exposure below 50%.  Keep in mind, these are not permanent exposure levels. 

2)You could move some money out of U.S. equities into International where valuations are much more attractive…especially emerging markets.

3)Lower your expectations that stocks will deliver 10%+ per year forever.   We are living in a low return world now.  In the past, it worked well to save 10% of your income and make 10% per year on your investments.  If returns are going to be significantly lower in the future, you should consider a savings rate closer to 20%.  Much better to face this reality when you are young. 
 
 
 
 
 
 
 
 
 
 
 
 
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