Tell me what sales per share will be in twelve years’ time along with the profit margin and the price-to-earnings ratio, and I will tell you the price twelve years from now.
It’s just simple arithmetic. Easy, right?
Well, yes, it is actually not as difficult as you might think.
Talking about the S&P 500 (U.S. large company stock index), specifically, we know the rolling 12-year annualized sales growth has been about 3.4% with a relatively tight range of 2.7% to 4.6%. This uses data since 2000, a period that started at a peak, includes two recessions/bear markets and bull markets.
The profit margin for the same period has averaged about 9% ranging between 2% and 11.5%. The median margin was 10%. Long-term corporate profit margins are closer to 8%.
The third component is the price-to-earnings ratio (P/E) and is volatile. The P/E is the price that investors are willing to pay for each $1 of earnings and is largely driven by investor emotions, growth expectations and tolerance for risk/risk aversion. An asset that earns $1 and is priced at 20x earnings is priced at $20. That same asset with the same earnings priced at 30x is $30.
The median P/E going all the way back to 1929 is right about 17. There has only been ONE twelve-year period, out of a total of 82 rolling 12-year periods since 1929, where P/Es started AND ended the period above 25x. That one time? The 12-year period that just ended in 2020. And that was an aberration because the P/E ratio in 2008 of over 70x was an extreme outlier due to a severe drop in S&P 500 earnings (the denominator of the P/E ratio) that year. The P/E was about 20x in the years immediately preceding and proceeding.
In other words, if someone’s return forecast relies on permanently elevated P/Es, it’s a useless forecast.
Although there is volatility in sales growth year-to-year, over twelve-year periods sales growth tends to reside close to its long-term average within a relatively tight band. Sales growth is highly correlated with nominal GDP growth.
P/Es tend to oscillate around their long-term average, and 12-year periods that start with a high P/E tend to end at a much lower P/E closer to the long-term average.
12-year return forecasts are much more reliable and more likely to be accurate and meaningful while shorter time frames are unpredictable. It’s a fool’s errand to make short-term return forecasts with any level of confidence. It’s even worse to build an investment strategy and financial plans around such unreliable forecasts.
However, it is critically important to understand return scenarios for twelve year periods in order to optimize investment decision making, minimize risk of your emotions infiltrating your investment process and build robust, useful financial projections and retirement plans.
In that spirit, let’s look at a 12-year gain/loss forecast for the S&P 500 using data available as of 3/31/2021.
S&P 500 Sales Per Share: $1,394
Long-Term Annualized Sales Growth Rate: 4%
Implied Future Sales Per Share in 12 years: $2,231
Profit Margin: 10%
Implied Future Earnings Per Share: $223
Long-Term Median P/E Ratio: 17x
Implied S&P 500 Level in 12 Years: $223 earnings per share x 17 P/E = $3,791
Implied Appreciation on S&P 500 Level over 12 years: 16% decline
Add 1.3% annualized dividends and U.S. stock investors will be lucky to eek out a positive total return (before taxes and expenses) over the next twelve years. And this analysis even assumes generous sales growth and margin assumptions.
Note that if today’s market were valued at 20x earnings (still above long-term average of 17x) instead of 35x, the S&P 500 would be about $2,600, which would provide about 50% appreciation up to $3,791 in scenario above. This is what I mean when I say things like “returns have been pulled forward and now lie in our past” and “the price you pay determines your return.”
But I like to prepare a matrix to see a range of possibilities under a variety of assumptions (see below). Remember, this doesn’t include dividends so to arrive at total returns (gross of fees and expenses) add about 1.3% per year for dividends.
Note there is only one scenario within this matrix where the S&P 500 is higher in twelve years than it is today. That single scenario requires higher than average sales growth for twelve years, higher than average profit margins in the final year, and higher than average P/E ratio at the end even though we’re starting the period with a very high P/E ratio meaning it’s more likely P/E ends the 12-year period near its long-term average of 17x.
The low returns across the matrix are not a result of pessimistic assumptions. On the contrary, we’re using a range of assumptions around the long-term averages. The low returns are the result of an extremely high market value today at the starting point. So, I repeat, “the price you pay determines your return.”
Now imagine what happens when we likely get a recession at some point in the interim that produces a sales decline of 10% in a year, margins drop to 5% and P/Es hold on to a historically-high 30x. Assuming that recession starts two years from now, U.S. stock investors would be looking at about a 60% loss from current levels in a few years’ time.
In other words, anyone contemplating an overweight to U.S. stocks right now is completely ignoring fundamentals of stock market returns, historical data and historical outcomes. Overweighting right now is simply a gamble that relies on very unlikely, unreasonable assumptions simply to break even on the “bet.”
Investors hinging their retirements on unlikely, unreasonable assumptions is dangerous. Unfortunately, most don’t even realize that they’re doing it. Even if they have an advisor, the advisor is likely also unaware of the highly unrealistic assumptions that would need to materialize simply to produce a positive return on U.S. stocks net of taxes and expenses over the next decade.
There are better ways to manage a portfolio through periods like this (i.e. being nimble). There are better assets to own at various times throughout the market cycle…especially at what appears could be near a generational peak. Lastly, financial projections / retirement plans need to incorporate realistic assumptions so that better financial decisions are made.
And I am here to help you navigate and provide the services you need.
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.
Views provided here are current only as of the moment of posting and are subject to change at any time without notification.