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Ten years ago, there were three schools of thought about how American stocks would fare during the next decade.
The mainstream belief, widely held by everyday investors, was that US equities would gain an average of 10-12% per year. After all, that was their long-term annualised rate of return, according to the popularly cited data from Ibbotson Associates, which dated to 1926. Why doubt the track record?
Most investment experts thought differently. Those were the recorded numbers, all right, but conditions had changed. By historical standards, the yield on stocks was low, their prices were high, and the nation’s gross domestic product growth was sluggish. Best to shave that annual estimate to 7%-8%. Warren Buffett believed that, as did Jack Bogle, as did Wharton’s Jeremy Siegel.
The third group was the pessimists. Largely guided by statistics such as the Shiller CAPE ratio, they argued that US equity valuations had already crossed that line. Yes, stocks had briefly become cheap after the 2008 global financial crisis, but by 2014 they had fully recovered. Stocks were due for a comeuppance.
Schiller CAPE Ratio
Robert Schiller Data as of June 16 2024
Only twice in the previous half-century had the CAPE ratio been higher than in spring 2014: during the late 1990s and the mid-2000s. As with bars at 2am, nothing good happened after either of those occasions. Perhaps equities would not crash this time around, but they surely wouldn’t thrive. At best, they would eke out a humble nominal annualized gain, say, 2%-3%.
The Results
To the surprise of the experts and the utter dismay of the pessimists, US equities ignored the concerns and proceeded on their merry way. The chart below shows the annualized total return for the S&P 500 from June 2014 through May 2024, along with the outlooks from the forecasting schools.
Total Returns
Morningstar Direct Data as of June 16
Even better than before! That said, the picture is incomplete because it considers only nominal returns. What matters, of course, is after-inflation performance. To what extent did owning a US equity portfolio increase a shareholder’s purchasing power? I redid the exercise using a 2.25% expected inflation rate for the forecasters. (That was not only a common prediction, but also the prevailing breakeven inflation rate on 10-year Treasury Inflation-Protected Securities.)
Real Returns
Source: Morningstar Direct, author’s calaculations, data as of June 16 2024
Incorporating inflation slightly shrinks the victory margin because actual inflation was modestly above the marketplace’s expectation. But the essential story remains unchanged. High valuations and slowing economic growth notwithstanding, equities performed better than almost anybody envisioned.
(Note: Real returns plus inflation do not necessarily sum to nominal returns because the components of investment performance are multiplicative, not additive. For example, a stock that records a 4% capital gain while paying a 4% dividend has an 8.16% total return.)
What Happened?
So far, I have decomposed equity returns into two factors: a) before and b) after inflation. But they can properly be separated into four components: 1) inflation, 2) dividends, 3) earnings-per-share growth, and 4) valuation. In other words, a stock’s real performance equals the dividends that it pays, multiplied by its change in earnings per share, multiplied by the change in price multiple that the stock commands – to which inflation’s effect must be considered.
To determine the experts’ estimates for those items, I tracked down a 2014 report from J.P. Morgan Chase (JPM). Although its figures are proprietary, they closely match those suggested by Buffett, Bogle, and Siegel. Such was the informed consensus. Below, I display the paper’s “10- to 15-year” projection for the four equity-return components, along with what actually occurred.
Return Components
Sources: Morningstar Direct, Robert Schiller, JPMorgan Chase, author’s calculations, data as of June 15, 2024
(Note: as you may have noticed, the numbers in J.P. Morgan Chase’s paper do in fact sum, rather than multiply. Not everybody is pedantic.)
Let’s grade the accuracy of each prediction, from best to worst.
1) Inflation: A-. The forecast slightly exceeded the stated target before the postpandemic spike, then finished slightly below. In either case, both the experts and the TIPS marketplace proved trustworthy.
2) Dividends: C+. At 1.87%, the dividend rate fell well short of the paper’s 3% estimate. Its authors were on the right track, writing that companies would “favour payouts over new investment.” But those payouts increasingly consisted of stock repurchases instead of dividends.
3) EPS Growth: C-. The error was larger yet with earnings growth, which surpassed expectations for two reasons. One, the stock buybacks reduced the number of outstanding shares, thereby shrinking the calculation’s denominator. Two, as I mentioned in last week’s column, the nation’s politics helped investors. Populism rose, but the anger was aimed largely at the federal government, not corporations.
4) Valuation: D. Perhaps that grade is overly generous. At any rate, very few investment experts, if any, believed that the stock market’s price/earnings ratio would increase over the next decade. In anticipating that the ratio would remain flat, rather than revert toward the historic mean, the paper’s authors were relatively optimistic.
Looking Forward
My grades, I must confess, were harsh. On their own, neither the predicted dividends nor real EPS growth was especially accurate. When evaluated together, though, the forecasts were almost spot on. J.P. Morgan Chase’s paper – which, again, is an apt summary of the institutional consensus – expected those two factors to deliver a combined 5.25%. The true figure was 5.69%.
While economic disaster is always a possibility, it’s reasonable to expect a similar figure over the next 10 years. Let’s say, to be slightly conservative, it’s 5%. If inflation were to average 3%, that would make for an 8% nominal return if price/earnings ratios remain constant. (This time, I will not be pedantic and multiply the figures; after all, this is merely a back-of-the-envelope musing.)
Of course, the price/earnings ratio for US equities might slide. I will not predict that event, because I have watched too many such prophecies fail. Should that decline occur, though, the nominal annualised return for US equities through the next decade, assuming a 5% contribution from dividends/EPS growth and a 3% inflation rate, would be 6.9% if the market’s price/earnings ratio falls by 10% over that period and 5.7% if the ratio drops by 20%. That’s a far cry from the previous decade’s 12.6% but still above what bonds will provide.
To answer this column’s opening query: yes, stocks can repeat their feat, although I do not think they will. Perhaps a better question is whether US equities should remain an investment cornerstone, not just for American investors, but for shareholders worldwide. I don’t see why not.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies
The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints
