2010-2020 produced better returns than the historical averages: From the start of 2010 until today, 27th of July 2020, S&P 500 returned 250% (dividends reinvested), which is a CAGR of 13.3% annually. Pretty impressive! Is it realistic to expect the same or at least close to 13%?
Typical after a decade of strong returns, optimists dominate the more prudent and realistic investors (in my opinion). Recency bias is hard to overcome; we tend to anchor our future predictions on the most recent past. I believe the next decade will be “disappointing”. Especially the youngest investors, who have seen nothing but rising prices, can get a real punch in the face. I believe these factors stop the party:
Most likely no or little multiple expansion:
During the last decade the stock market had a huge tailwind in the form of multiple expansion. At the start of 2010 the S&P 500 had an earnings multiple of around 18, while currently at around 28. This tailwind equals around 4.5% annually. Of course, the multiples can continue to expand, but I’m certainly not putting that into my calculations. Low interest rates are already discounted for years to come.
Low interest rates:
About 14 trillion USD worth of bonds have negative nominal yields. Would you invest in long-term treasuries which pay a coupon significantly less than inflation, even negative nominal rates? I wouldn’t, and the remaining viable investment options are stocks and real estate. Current earnings yield for stocks are 3.6% (P/E upside down). Compared to a yield of 0.7% for 30 year bonds it doesn’t seem so bad. But the margin of safety is small, in my opinion.
The US dollar:
Can we expect a lower USD? Forex goes in cycles, and the FED has expressed explicitly they aim for lower rates than the general inflation rate (CPI). Race to the bottom?
More economies are “maturing”, translating into slower growth and low birth rates. Furthermore, we see an unwelcome rise in youth unemployment, a potential destabilizing factor both socially and politically. Can youth unemployment potentially create a “black swan“?
The birth rate in all OECD countries are very low, way below the 2.1 children per woman required to keep status quo. In Eastern Europe it’s even worse with both low birth rates and massive emigration. This trend is likely to continue.
In their effort to “save” the economy, central banks have started buying government bonds and corporate bonds. Loss aversion has its price: According to Wall Street Journal the number of zombie companies is at all time high.
This might save the economy short-term, but the long-term effect is yet unknown. I suspect central banks are sweeping the problems under the carpet. Capitalism is not perfect, but one of the prerequisites is what Schumpeter called creative destruction. Destruction to create something new is a necessarily evil.
Low hurdle rate:
The low interest rates set the bar low for companies’ hurdle rate. This makes it easier for “zombie” companies to survive, and thus poor capital allocations for society as a whole and subsequently lower growth.
High debt levels:
Both corporate and sovereign debt levels are at all time high. This makes both types of institutions very fragile. The problems are forwarded to future generations, which are already struggling to find employment.
What about inflation?
During the Covid-19 crisis the FED has been literally printing dollars. Despite being the world’s reserve currency, I believe there is a limit how long this can continue without consequences. Inflation is always a result of supply, and at one point the faith in the USD may crack. It’s impossible to say when, and it will be no warning signs in advance (if it happens).
As of writing the gold price is at the highest price since 2011, just a tad away from all time high. Gold serves as a hedge against inflation, and yet again many investors seek protection in gold. Most investors are well aware that gold has beaten the CPI since the dollar was pegged to gold.
Despite high gold prices, I believe most investors expect inflation to be low. But who knows? We’ve had 40 years with benign inflation. Inflation has been subdued or falling since the early 1980s. Most investors have long forgotten what inflation is and what a destructive force it is. I expect stocks to somewhat keep up with inflation in a rising CPI scenario, but the stagflation in the 70s made stock market return pretty modest.
Is Japan relevant?
Japan has already suffered two decades with both low rates and growth. It’s hard to tell if Japan bears any relevance to the rest of the world, but if you believe so, press this link to read about their returns on the different asset classes since 1999.
Earnings growth (conclusion):
All the factors mentioned above has the potential of lowering the future returns. But what kind of returns can we expect? According to this site the EPS growth in S&P 500 has averaged about 5% since 1990. By using the late John Bogle’s very simple formula of calculating future returns, we can play with some numbers:
1.93% (current dividend yield) + 5% (earnings growth) – 1% (multiple contraction) = 5.93%.
(This article was published on the 28th of July 2020.)