The Painful Math Behind the U.S. Stock Market

The market continues to be on a tear with the S&P 500 up 400% since the low in March of 2009.  This works out to a compounded annual return of 15.9%.  Can this pace continue?  In the short term, maybe.  In the long term, I seriously doubt it.  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.
 
Everyone is asking the questions “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”.  Pay attention to the people who are actually running money and have a long track record of success.  This would include people like Warren Buffett, Seth Klarman, or Howard Marks.  When they are asked these questions, they respond with honesty “I don’t know”.
 
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 very 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.  That’s an 11-year compounded annual return of nearly 16%.  Today, the S&P is at 3,375 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%
      2020 (S&P 500)                                                      ?
 
You know from my past posts I like to break down the components of equity returns to project what future returns are likely to be.  These components are:
 
1) Real GDP growth:  Consensus is around 2% per year which is in line with the past 12 years.  With population growth at a fraction of a percent, it is difficult to generate much higher rates of growth.
2) Inflation: 1.7%.  This is what is currently priced into the fixed income market for the next 10 years.
3) Dividend Yield:  1.8%.  This is today’s yield on the S&P 500.
4) Change in Price/Earnings Ratio: -5.8%.  Today stocks are trading at 30x normalized earnings vs. a long-term average of 16.5x.  This has only happened a few times in history and over time it has always reverted to the mean of 16.5x.
 
Add it all up and you get to a projected annual return estimate of -0.3% for the next 10 years. To be fair, some argue that as long as interest rates remain low, we could remain at record high valuations without reversion to the mean.  I’m skeptical, but if that were to happen, you would be looking at 5.5% annual returns going forward.  Now you have to ask yourself if you are willing to risk a 30-50% decline in order to enjoy this annual return.  This will be a function of age, risk tolerance etc. but I always say young people don’t like losing money either.
 
I understand the dilemma....there is even a term for it called “TINA”.  “There Is No Alternative”.  Cash is paying close to zero, safe bonds are paying closing to zero, longer term bonds & junk bonds provide some yield but they have the added risk of losing money if interest rates climb.  Personally, I think this TINA approach is a dangerous way to think about investing.  “I know stocks are overvalued but I’ll buy them anyway because the alternatives are no 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 been doing very well
 
      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 attractive or
B) Risk losing 30-50% 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 (see my past blog about safe places to park cash).  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 50% invested.  If you are old and stocks are cheap, you might go with 75% exposure.  I’m old and stocks are expensive, so our exposure runs 25-35%....and it’s all in International stocks.
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. 
 
Whatever I do, I feel better using the SWAN method. (Sleep well at night)
 
 
 
 
 
Questions or comments, feel free to email me at [email protected]
 
 
 
 
 
 
 
 
 
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