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Forward Returns Will Likely Disappoint Compared to the Past Decade

Published 01/03/2023, 03:30 PM
Updated 02/15/2024, 03:10 AM

For many investors who started their investing journey following the financial crisis, forward returns will be disappointing compared to the last decade. But it won’t be solely due to high valuations.

I recently discussed why the next Secular Bear Market may have started, which touched on the issues of valuations and forward returns. To wit:

“Three items drive secular bull markets: 1) valuation expansion, 2) earnings growth and 3) falling interest rates. The most prominent driver of secular returns are periods of valuation expansion and contractions.”

SP500 Secular Markets Valuations

“The chart above shows the history of secular market periods going back to 1871 using data from Dr. Robert Shiller. You will notice that secular bull markets begin with CAPE valuations around 10x earnings or even less. Secular bear markets tend to start with valuations of 23-25x earnings or greater. (Over the long-term, valuations do matter.) Most notably, secular BEAR market periods are defined by near-zero returns during the valuation contraction process.”

As we know, a decent correlation exists between future returns and current valuations

Forward 10-Year Real Total Returns Correlation

As we have often stated, such does not mean that every year over the next decade will foster low returns. It only suggests that the total return will be low over the entire decade. History shows that such is the case.

“Notably, as an investor, only 5-periods are secular bull markets (where prices are increasing) over the last 150 years. Those five periods account for 100% of all the index gains. In other words, the outcome was disappointing if you invested on a buy-and-hold basis during any other period.”

SP500 Valuations - Secular Cycles

However, another reason forward returns will likely be substantially lower than in the past has nothing to do with valuations.

The Monetary Illusion Of Growth

How often have you seen the following chart presented by an advisor suggesting if you had invested 120 years ago, you would have obtained a 10% annualized return?SP500-Real Price Index History

It is a true statement that over the very long term, stocks have returned roughly 6% from capital appreciation and 4% from dividends on a nominal basis. However, since inflation has averaged approximately 2.3% over the same period, real returns averaged roughly 8% annually.

The chart below shows the average annual inflation-adjusted total returns (dividends included) since 1928. I used the total return data from Aswath Damodaran, a Stern School of Business professor at New York University. The chart shows that from 1928 to 2021, the market returned 8.48% after inflation. However, notice that after the financial crisis in 2008, returns jumped by an average of four percentage points for various periods.

Average Annual Returns By Period

After more than a decade, many investors have become complacent in expecting elevated rates of return from the financial markets. During that period, investors developed many rationalizations to justify overpaying for assets.

However, the problem is that replicating those returns becomes highly improbable unless the Federal Reserve and Government commit to ongoing fiscal and monetary interventions. The chart below of annualized growth of stocks, GDP, and earnings show the outsized anomaly of 2021.SP Growth of Earnings Price and GDP Average Returns

Since 1947, earnings per share have grown at 7.72%, while the economy has expanded by 6.35% annually. That close relationship in growth rates is logical, given the significant role that consumer spending has in the GDP equation.

The market disconnect from underlying economic activity over the last decade was due almost solely to successive monetary interventions leading investors to believe “this time is different.” The chart below shows the cumulative total of those interventions that provided the illusion of organic economic growth.

Government Interventions vs Economic Growth

Over the next decade, the ability to replicate $10 of interventions for each $1 of economic seems much less probable.

A Return To Normal

Over the last decade, massive monetary interventions distorted financial markets from their respective underlying economic linkages. As noted above, the deviation from long-term growth trends is unsustainable, particularly when factoring in demographic trends.

Over the next decade, the elderly population will begin systematically withdrawing assets from the market for retirement. Given the rise in individuals approaching retirement against a declining working-age population, the problems for pension and welfare systems become more apparent.Working Age to Elderly Population

Nonetheless, economic growth will run below previous trends between an aging demographic of accumulators becoming net distributors of assets and less monetary support in the future.

Therefore, returns must revert to historical norms. Such will result from profit margins and earnings returning to levels that align with actual economic activity.Cumulative Change Profits vs Market

Of course, one must also consider the drag on future returns from the excessive debt accumulated since the financial crisis.Total System Leverage

That debt’s sustainability depends on low-interest rates, which can only exist in a low-growth, low-inflation environment. Naturally, low inflation and slow growth economy do not support excess return rates.

It is hard to fathom how forward return rates will not be disappointing compared to the last decade. However, those excess returns were the result of a monetary illusion. The consequence of dispelling that illusion will be challenging for investors.

Does this mean investors will make NO money over the decade? No. It means that returns will likely be substantially lower than investors have witnessed over the last decade.

But then again, getting normal returns may be “feel” very disappointing to many.

Latest comments

Interesting article but the working-age vs elderly population chart seems kind of misleading.
Very informative.
Future geopolitical and economic uncertainty make stock market prediction an exercise in futility. Buy and hold is no longer a prudent strategy in my view...it is more closely aligned with gambling. Trade what you see not what you believe.
Thought provoking article. It would be great for the author to cover the logical follow-up question: given this situation, what does he recommend for an investor?
It’s difficult to do that specifically because it depends on your personal risk tolerance and investment time horizon. Regardless, equity markets will likely be negative this year outside of a fortunate sector or two, and most will be flat at best. Buying and rebuying short term bonds (type dependent on your risk tolerance) would allow you to at least achieve some growth without keeping your money tied up so long that you miss out when the next bull market starts up. There isn’t much else for a passive investor in the foreseeable future.
No printing, no party baby! Fantastic article again from Lance
I remember reading a similar article in 2019 by Vanguard.
Interesting article.
tu sais pas mon pote,tu connais pas avenir.arrete avec tes article de merde
you can't invest without trying to forecast the future
yes you can. I do it everyday.
you can also gamble
Excellent Analysis as Always. Thank you
Wild guess
Interesting article.
Interesting article.
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