I’d say this is getting boring, but it’s pretty fascinating watching the rally run. ?Now, this is the seventh time I have done this quarterly analysis. ?The first one was for December 2015. ?Over that time period, the expected annualized 10-year return went like this, quarter by quarter: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%. ?At the end of June 2017, the figure would have been 4.58%, but the rally since the end of the quarter shaves future returns down to 4.30%.
We are now in the 93rd percentile of valuations.
Wow.
This era will ultimately be remembered as a hot time in the markets, much like 1965-9, 1972, and 1997-2001.
The Internal Logic of this Model
I promised on of my readers that I would provide the equation for this model. ?Here it is:
10-year annualized total return = 32.77% – (70.11% * Percentage of total assets held in stocks for the US as a whole)
Now, the logic of this formula stems from the idea that the return on total assets varies linearly with the height of the stock market, and the return on debt (everything else aside from stocks) does not. ?After that, the formula is derived from the same formula that we use for the weighted average cost of capital [WACC]. ?Under those conditions, the total returns of the stock market can be approximated by a linear function of the weight the stocks have in the WACC formula.
Anyway, that’s one way to think of the logic behind this.
The Future?
Now, what are some of the possibilities for the future?
Above you see the nineteen scenarios for where the S&P 500 will be in 10 years, assuming a 2% dividend yield, and looking at the total returns that happen when the model forecasts returns between 3.30% and 5.30%. ?The total returns vary from 2.31%/year to 6.50%, and average out to 3.97% total returns. ?The bold line above is the 4.30% estimate.
As I have said before, this bodes ill for all collective security schemes that rely on the returns of risky assets to power the payments. ?There is no conventional way to achieve returns higher than 5%/year for the next ten years, unless you go for value and foreign markets (maybe both!).
Then again, the simple solution is just to lighten up and let cash build. ?Now if we all did that, we couldn’t. ?Who would be buying? ?But if enough of us did it such that equity valuations declined, there could be a more orderly market retreat.
The attitude of the market on a qualitative basis doesn’t seem nuts to me yet, so I am at maximum cash for ordinary conditions, but I haven’t hedged. ?When expected 10-year market returns get to 3%/year, I will likely do that, but for now I hold my stocks.
PS — the first article of this series has been translated into Chinese. ?The same website has 48 of my best articles in Chinese, which I find pretty amazing. ?Hope you smile at the cartoon version of me. 😉
Wouldn’t this model give the exact same answer if the labor force shrunk by 10% tomorrow? I think i’d prefer something that combines your logic with some underlying measure of productive capacity. Given low population & labor force growth, this might become more relevant than it has in the past.
It would give the same answer. Labor isn’t relevant here; it is a very second-order concern. The portfolio decisions of investors do matter. Every model has limitations. This one is better than the rest, but if you can create a better one, go publish it.
Do you have a similar analysis for international or EM stocks?
No, this is based off of US data in the Z.1 report, and not many nations collect that. It is a luxury, and surplus economists at the Fed don’t have enough to do…
Nice Article. Thanks for sharing. I just want to know which tool you usually used for technical anlysis.
I don’t do technical analysis. On rare occasions, I look at money flow, momentum, mean-reversion, and where the 200 DMA is, but I only use those for bonds.
Okay Sir.!! Thanks
I’ll preface this with I don’t understand your model.
I do agree future returns will be lower than historical; just not that low.
Truth is we’ve been building capital for 70 years. The best ideas and highest return projects are gone. You need something like WWII that destroys a lot of capital to give new investors high return investments. This is one reason why the level of interest rates continues to fall which also causes the other risks buckets like equity markets to have their long-term rate of return fall.
I think the market is still offering a better return than you indicate. Even the tech leaders that all seem to have great moats offer much better returns than bonds. I mean google is only at a low 20 pe with 20% yearly growth (not sure how long they can maintain that); but obvious that is going to beat a 2.9% 30 year by a wide margin.
I’m fully bullish. I think we are entering a great moderation and interest rates are staying below 4%. At that return equity markets offer a very compelling risk-reward. I’d rather buy cheaper, but I don’t see that happening.
Google may beat the 30-year T-bond over the next ten years; it also may not. You may think you are looking through the windshield, but you are looking through the rearview mirror. Debts in the economy are growing faster than profits. GDP growth is slow, constraining growth in profits. At the same time, valuations for risk assets have risen across the economy as a whole — this applies to real estate, private equity and public stocks.
As the total value of equities in the economy has risen, the “owner earnings” that the equities throw off has not kept pace. That adjusted E/P ratio points to 4% returns for the next 10 years. Remember, the earnings Wall Street advertises overstates the real trailing earnings by around 30% on average. That yields on Baa corporates are approaching the earnings yields on stocks should give everyone pause, because it means in aggregate stocks are earning the cost of capital and no more.
Momentum can carry the market higher, but there is no longer anything fundamental behind this rally.