Compare and Contrast

Executive Summary
Today, I want to compare the investment opportunity set in U.S. stocks between 2008 and 2020. I hope this exercise helps illustrate a critical point I’ve been making.

First, we need to understand the three components of stock returns.

  1. Dividend Yield
  2. Earnings Growth
  3. Price-to-Earnings Multiple

Dividend yields are fairly stable and predictable. The current dividend yield of the S&P 500 is about 1.5%.

Earnings growth is a function of (1) sales growth and (2) profit margins.

The price-to-earnings ratio (P/E Ratio) simply reflects how much an investor is willing to pay for each $1 of earnings. This is largely a measure of investors’ emotions and tolerance (or lack thereof) for risk and can swing wildly.

Short-term returns are so difficult to predict because unanticipated recessions and financial crises (or even global pandemics) can cause a sharp drop in sales thereby impacting earnings. Additionally, investor emotions can swing wildly so predicting the P/E ratio is impossible over short periods of time.

For example, last year earnings for the S&P 500 are estimated to have declined about 14%, however, the PE ratio skyrocketed to about 34x earnings. Therefore, even though we were in the midst of a global pandemic, earnings declined, millions of people lost their jobs and businesses shuttered the S&P 500 managed to have a great year.

However, longer-term returns (10-12 years) are easier to predict as much of the short-term noise and cyclicality is averaged out. For example, we know profit margins are cyclical but tend to oscillate around 6%-8%. PEs also tend to be cyclical with a long-term average of around 17x. And sales growth is highly correlated with GDP growth.

Return Matrices
Knowing these components of returns allows us to build a return matrix with potential returns under a variety of scenarios for each of those factors.

This first matrix shows various cumulative price (excl. dividends) returns for the next twelve years. The second matrix shows the same but as of 12/31/2008 to illustrate the stark contrast between the two starting periods.

What do we notice when comparing the two charts?

  1. There is A LOT of red on the 2020 chart. This means there are many more scenarios where the S&P 500 loses money over the next twelve years.
  2. The few positive return scenarios over the next twelve years require some pretty extreme (bullish) conditions to be sustained.
  3. The few positive return scenarios for the next twelve years are only mildly positive.
  4. If we manage to achieve average sales growth (4%), average profit margins (6%-8%), with an average P/E of 17x we’re looking at about a 20% to 40% loss in the S&P 500 over the next twelve years (not including dividends)!
  5. The 2008 period shows a lot more opportunities for positive returns and the potential returns were enormous from that point in time. Positive returns were to be had quite easily from that point in time even with conservative assumptions for the various factors.

The investment opportunity set was much more attractive in 2008 than it is today. The risk (i.e. potential for severe losses) of investing in U.S. stocks today is quite large while the potential returns are quite small. That’s a poor risk / return tradeoff. In fact, today’s risk / return profile of U.S. stocks is about the worst it’s been in history.

This is why I’m managing portfolios relatively conservatively at the moment and including other assets besides U.S. stocks.

This is also why it’s critical for people approaching retirement (or recently retired) to ensure their financial projections, upon which I presume major financial decisions are being made, are incorporating realistic return assumptions as opposed to lazily relying on historical averages or even optimistic returns.

Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.

Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.

This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.

S&P 500 sales per share assumed to be $1,400 for 2020 although that’s just an estimate.

Views provided here are current only as of the moment of posting and are subject to change at any time without notification.