As 2024 opens, we are reminded that the work we do is all about remembering the basics and maintaining our composure in the face of uncertainty. The world seems to fuel itself on uncertainty in increasing volume, but thankfully the laws of humanity and even of some sciences (like investing) still track very familiar patterns.
Adaptation, curiosity, intuition, and many other human qualities make progress possible. And most of all we trust in our work, and in one another. Trust is about selecting who you travel with on this journey we call life. It matters a lot. And we are reminded that reviewing the basics is always an exercise in testing who and what you still trust.
In the past, we have commented on the futility of making (or at least putting heavy reliance into) short-term forecasts of the direction of the stock market, the economy, or interest rates. These systems are far too complex to be modeled and predicted in the short run with any consistency (although building forecasts is useful for sharpening our thinking around potential investment opportunities).
Is It Possible to Forecast Stock Market Returns?
While short-run forecasting of the stock market is extremely chancy, forecasting long-run returns, such as 10-year returns, is really fairly simple and reasonably useful. So for those who want to plan ahead, let’s give it a try. Let’s test the basics and see what we come to as a result.
In the long run, freed from the moods and investment fads of the moment, the stock market will return exactly the sum of its earnings growth rate, its dividends paid and any change in the price/earnings ratio of stocks from start to finish. That’s it. If we can reasonably project these three elements, we have a forecast. We believe in this.
How Does Inflation Affect Such Forecasts?
The earnings growth rate of U.S. stocks as a group tends to track the average annual growth of the economy, including inflation. Fortunately for us, the average annual growth of the economy will be comprised of growth in the labor force, quite steady over time at 0.5%; growth in the productivity of labor, also quite steady at a normal 1.5%; and the average rate of inflation.
Although the rate of inflation has varied wildly of late due to the displacements of the COVID shutdowns and then the burst of consumption post-shutdown, the average rate of inflation over the past 60 years has been 3.8%. We think that due to changes in the economy, that 3.8% number will be a little too high, but we also think a structurally tight labor market will prevent a return of inflation at the Federal Reserve target of 2.0%. We will assume an average rate of 3.5%. Based on these inputs, the average earnings growth for U.S. stocks over the next 10 years should be around 0.5 + 1.5 + 3.5 = 5.5%. (Annual earnings growth over the past two decades has exceeded GDP growth due to shifts in our economy from manufacturing to services, but we believe that earnings-enhancing shift is largely over.)
Calculating dividends paid is easy. The current yield on the S&P 500 Index is 1.6%, and we assume that dividends will grow at about the same pace as earnings, say 6% per annum. If that is close to the mark, we see dividends paid over the next 10 years averaging about a 2.0% return.
The Impact of the Earnings Multiplier on Stock Market Returns
Finally, the big swing factor from one decade to the next has always been changes in the earnings multiplier over the course of the 10-year period. Today, the S&P 500 Index calculation, dominated by very large, very, very profitable companies (think Apple, Google, Facebook, NVIDIA, Microsoft, a few others) trades between 19 and 20 times current earnings. A more normal valuation would be 17.5-18.0 times earnings, so the S&P 500 appears to be about 10% overpriced. If we assume that by Year 10, the valuation will be normal, then we need to deduct 10%, or about 1% per annum, from our return calculation, leaving us with a final return projection of 5.5% + 2.0% -1.0% = 6.5%.
Is this reasonable? The Leuthold Group, an investment advisory and research firm, undertook a calculation of all rolling 10-year returns on stocks from 1926 through 2011, and it found that when the starting valuation was as elevated as today’s, the subsequent 10-year return averaged 6.8%. If the next 10 years resemble market history, our 6.5% projection, while undoubtedly uncertain, appears to be reasonable.
Now For Some Good News…
Although the very largest company stocks sell for high price-earnings ratio and thereby stretch the valuation of the S&P 500, the great majority of U.S. stocks are selling at much lower valuations. For example, smaller company U.S. stocks are currently valued, as a group, at about 15 times current earnings. It would be consistent with market history to expect them to produce returns more in line with their historical average of 10% per annum. While the very expensive large company stocks have exciting technologies that dominate the news cycle (think Tesla with EVs, Microsoft with artificial intelligence, Apple with new devices, etc.), there will still be growth ahead for smaller companies that meet our basic needs on a daily basis. Now might be a good time to diversify holdings to include some of those smaller company stocks or exchange-traded funds, something we at MONTAG have been discussing for months. Changes in this vein are on deck and occurring. Your portfolio manager likely has already discussed this topic with you, or will if you ask.
At MONTAG, we are about adapting and maintaining our curiosity and using our intuition. And we appreciate the chance to work for you as we do.
The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. These analyses have been produced using data provided by third parties and/or public sources. While the information is believed to be reliable, its accuracy cannot be guaranteed. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed were or will be profitable. MONTAG employees do not provide legal or tax advice. For specific legal or tax matters, you should consult with your own legal and/or tax advisors. There are risks associated with investing in securities. Investing in stocks, bonds, exchange-traded funds, mutual funds, and money market funds involves risk of loss. Loss of principal is possible. Sources used for this article include yardeni.com, bls.gov, worlddata.info, and schroders.com.