Back in January, I wrote in Economy & Markets that U.S. stocks were priced to deliver returns of about 0.3% per year over the next eight years. Today we’re going to update that forecast based on current valuations and dig into the details of what those kinds of returns would actually look like in practice.
First, the bad news. After the monster rally we saw in February, U.S. stocks are now priced to deliver returns of negative 0.3% over the next eight years.
The -0.3% return forecast was based on the current reading of the cyclically-adjusted price/earnings ratio (“CAPE”), which now sits at a very bubbly 27—about 63% higher than the long-term average of 16.6.
As a way of smoothing out the booms and busts of the business cycle that can temporarily inflate earnings and skew the traditional P/E ratio, the CAPE divides the current stock price by an average of the past 10 years of earnings.
Research site GuruFocus calculates the CAPE and then forecasts returns for the eight years ahead by adding three components:
- Dividend yield
- Economic growth (average of growth rate of past 8 years)
- Expansion or contraction of the CAPE to its historical mean
Today, the market’s dividend yield is very modest at 1.9%, and economic growth has been tepid at best. Even ignoring the recession years, real GDP growth has average only 2%-3% over the past eight years.
So, let’s say that for reasons we can’t imagine today, a CAPE of 27 become the new normal and we have no contraction in the multiple. Even in this fairy tale utopia we’d be looking at returns of only about 4%-5% per year. And I should reiterate that I would consider that wildly unrealistic.
So, let’s take the CAPE forecast at face value and assume that valuations eventually come back down to their averages. This gets us annual returns that are basically flat over the next eight years.
But what would that actually look like?
Let me put it to you like this. Markets don’t just stop moving for eight years at a time. Between 1999 and 2007, the S&P 500’s value was essentially unchanged. But if you recall, the market didn’t move sideways for that eight-year stretch. It lost half its value before eventually finding a bottom.
I don’t know what direction the market will take over the next eight years. But I’m confident in saying that U.S. stocks as an asset class are a terrible buy-and-hold investment at current prices. If you’re in the market, stay tactical. Don’t be afraid to sell and take a little risk off the table.
Better buying opportunities will come. They certainly did after both the 2000 and 2007 tops. In the meantime, be patient and bide your time.
