IMAGINE A MARKET genie offered you the choice between knowing the stock market’s return next year or the stock market’s average return over the next 10 to 15 years. Which would you choose?
I’m guessing that most people would prefer to know how the stock market will do next year. After all, that seems like more actionable information, plus who has the patience to wait a decade or longer? But for those with an investing time horizon of more than 10 years—the vast majority of us—knowing the stock market’s return over the next decade or longer is far more valuable information.
What’s more, you don’t need to cross paths with a stock market soothsayer to learn this. With some simple arithmetic, anyone can estimate the stock market’s return over the next decade with a fair degree of confidence.
Stock market returns are a function of three variables. Two of them are fundamental and have to do with the dividends that stocks generate. The third variable—”animal spirits,” for lack of a better phrase—is the most elusive and relates to the price investors are willing to pay for a dollar of dividends or earnings. As with many things in the stock market, animal spirits are impossible to predict in the short term but become far more predictable in the long run.
Let’s see what the future holds for the U.S. stock market, using the S&P 500 as our benchmark. The first variable is the current dividend yield. This is the stock market analog to a bond’s yield-to-maturity, which closely approximates the expected return on a bond or bond fund. For the S&P 500, the current yield is 1.4%. That was easy, right?
But unlike bond coupons, stock dividends are not fixed, but rather they grow over time. Therefore, the second variable is the growth rate of dividends. While it’s impossible to know this number with absolute precision, dividends have had a fairly consistent growth rate historically, averaging around 5%.
So far, this has been a cakewalk. Now we get to the third and final variable, the one I’m calling animal spirits. This factor amounts to determining how much investors are willing to pay for a dollar of dividends or earnings. While it may seem impossible to quantify this variable—and, over the short run, it is—it turns out that we can account for animal spirits over the long run.
To do this, we use two investing tools: the CAPE ratio and reversion to the mean. The CAPE ratio was popularized by Yale University professor Robert Shiller. It stands for cyclically adjusted price-earnings ratio, which is a stock’s current price divided by the company’s average earnings over the past 10 years. Shiller has argued that the CAPE ratio is a truer measure of stock valuation since it uses a stock’s average earnings over an economic cycle.
The more common metric of market valuation, the price-earnings (P/E) ratio based on trailing 12-month reported earnings, is a lot noisier and can give false signals. For example, the collapse in corporate earnings over the past 12 months due to COVID-19 has skewed the P/E ratio higher, making it a less reliable gauge of valuation.
The CAPE ratio for the S&P 500 currently stands at 37.5. The long-term historical norm for the CAPE ratio is 16.6. Clearly, we are far above that average today. To know what this means for future returns, we rely on the tendency of stock markets to revert to the mean. We don’t know when stock prices will revert to the mean, but history has shown that markets do revert eventually. We rely on this phenomenon to estimate the third variable. If the U.S. stock market reverts to the mean over the next 10 years, that implies a drag on returns of -7.8 percentage points per year. But let’s be conservative and assume that markets only revert halfway—to a CAPE ratio of 27.1 (halfway between 37.5 and 16.6). If that occurs, it would produce a drag on returns of -3.2 percentage points per year.
Why only assume a halfway reversion to the mean? Because, in truth, expected returns are more an art than a science. Perhaps low interest rates persist over the ensuing decade. All else equal, this would justify higher stock prices. Maybe the risk premium for stocks drops permanently. Again, this would imply higher valuations for stocks.
For those of you who feel that I’m mixing apples and oranges by using dividends and CAPE ratios, you could substitute the dividend yield for the CAPE ratio and get very similar results. As it happens, S&P 500 dividend yields have averaged 2.8% over the past 50 years and 3.9% over the past 100 years. If we use 3% for the long-term average dividend yield and then assume reversion, we get nearly the same drag on returns that we just saw for the CAPE ratio.
Now we have our three variables in hand. All that’s left is some simple arithmetic:
Nominal expected return for the S&P 500 = 1.4% + 5% – 3.2% (halfway reversion to the mean) = 3.2%
Nominal expected return for the S&P 500 = 1.4% + 5% – 7.8% (full reversion to the mean) = -1.4%
But what about inflation? Let’s assume 2% inflation. The real (after-inflation) expected return for the S&P 500 over the next decade falls to just 1.2%, assuming halfway reversion. We are barely treading water. Should inflation run a tad hotter, the real return could easily fall to zero. And if the CAPE ratio reverts fully to the mean, real returns would be -3.4% per year. Yikes.
Despite today’s low dividend yields, some market observers are more sanguine. They say we should focus on dividends and stock buybacks. The combined “yield” on the S&P 500 due to both is about 3.2%, more than double the simple dividend yield. If stock buybacks continue at the same pace, future returns could be higher by nearly two percentage points a year. That means we could be looking at real returns closer to -1.4% (full reversion to the mean) or 3.2% (halfway reversion to the mean). This is better, but still nothing to get excited about.
Armed with such information, what’s a rational investor to do? Five immediate implications come to mind:
1. Save more. In building your nest egg, more of the heavy lifting will need to come from your savings rate. This is especially true since expected returns from bonds are equally paltry.
2. Work longer. This has two benefits: You’ll have more time to amass your nest egg and you’ll need a smaller nest egg, because your retirement will be shorter.
3. Look outside the U.S. The same calculation can be performed for international markets, both developed and emerging. Because these markets have higher dividend yields and lower CAPE ratios, they have higher expected returns.
4. Consider overweighting value stocks. The S&P 500 is expensive. But when you look under the hood, there’s a large divergence in price between growth and value. Growth stocks are pricey, while value stocks are much less so.
5. Lower your expectations, particularly for U.S. stocks. This is important because expectations drive behavior. When markets get pricey, we tend to increase our expectation for future returns, which is completely irrational. By lowering our expectations, we are more likely to do right by our portfolio—by rebalancing regularly rather than carrying an overweight in U.S. stocks and risking disappointing returns.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.