Updated 04/12/2024
Introduction to the Concept
The stock market’s return is a function of earnings, the earnings multiple and dividends.
Projecting forward returns requires just simple arithmetic. Let me show you.
Sales per each share of the S&P 500 for quarter ended 12/31/2023 was ~$490. Multiply that by four to get ~$1,960 annual run rate of sales per share.
Long-term average annual sales growth is 4%. So, apply a 4% average annual growth rate to $1,960 of sales for 12 years implies sales per share will be about $3,140 in 12 years.
Average profit margins for the S&P 500 is 8% to 10% so apply a 9% margin to $3,140 of sales implies ~$280 of earnings per share in 12 years.
The long-term average price-to-earnings multiple (P/E) for the S&P 500 is about 17x. So, multiply $280 of earnings by 17 to get an implied price of $4,760 for the S&P 500 in 12 years.
The price of the S&P 500 today, however, is $5,119 so the S&P 500 is currently priced to retreat about 7% over the next 12 years. U.S. stock investors are essentially just investing for the dividend, which is only about 1.4% currently.
Simple, right?
But, of course, we don’t know exactly what sales growth will be over any period of time, or what the profit margin and earnings multiple will be at any point in the future. That’s why I like to use a matrix to show a range of potential outcomes based on a variety sales growth, margins and P/E multiple inputs.
The good news is that over longer periods of time (i.e. 10-12 years) sales growth, profit margins and earnings multiples tend to oscillate around their long-term averages. So, by using a 10-12 year timeframe we can project a reasonable range of forward returns.
At a minimum, by performing this analysis, we get a feel for current valuations of the stock market in the context of history and develop a better understanding if returns might be higher than average, lower than average or in line with historical averages and better understand the risk / reward offered by the market.
This information can then be incorporated into personal financial projections to assist in building reasonable recommendations for savings rates, retirement age, financial goals, investment strategy, social security commencement, pension, etc…
A Matrix of Potential Forward Returns (Current)
Disclosure: This matrix does not include every potential return outcome. The purpose is to show a likely range of outcomes but cannot show every potential outcome. Actual outcomes could deviate significantly from the estimates.
Observe the range of returns is 5% annualized LOSS to a 4.0% annualized gain with an average estimate of essentially 0%. You might think this seems very low… because it is!
The long-term average annual return for the S&P 500 is closer to 8%-10%. This 0% return expectation for 12 years reflects that the U.S. stock market is extremely overvalued at the moment.
A Matrix of Potential Forward Returns (as of June 2009)
For contrast, I performed the exact same analysis but from a different point in time near the bottom of a market cycle (mid-2009) to show what a truly attractive period for U.S. stock might look like.
Notice in the case from 2009, using the exact same methodology, the range of returns was 4.0% to 13.7% with an average estimate of 9.1%!
The low end of that 2009 range is about equal to the high end of the current range. Furthermore, the 9.1% average estimate is in line with the long-term historical average for the S&P 500.
Certainly, the U.S. stock market provided a far more attractive investment opportunity back in 2009 than it does today based on this analysis.
Recall that 2009 was the bottom of the Great Financial Crisis where the U.S. stock market just lost 55% top to bottom. So, it makes sense that the valuations near the bottom in 2009 were relatively cheap and forward return estimates were, therefore, much higher.
Implications
This information is not at all reliable for predicting short-term returns, however, the implication is that U.S. stock market returns over the next decade or so will likely end up being significantly lower than historical averages.
Therefore, when preparing our financial projections upon which important decisions are made, we must set our return assumptions appropriately. By lazily relying on historical averages we are more likely to make poor, suboptimal decisions and/or take on far more risk than we’re comfortable with.
Bond Returns
Now that we’ve addressed forward stock return estimates, let’s do the easy one…bonds. Or, more specifically, treasury bonds.
The return of a treasury bond is simply the yield to maturity at purchase.
3-month: 5.5%
6-month: 5.4%
1-year: 5.2%
2-year: 5.0%
3-year: 4.8%
5-year: 4.6%
10-year: 4.6%
20-year: 4.8%
30-year: 4.6%
If you want to understand why the shorter maturities are providing a higher yield than longer maturities, I encourage you to watch this brief video where I answer that:
Why Are Long-Term Bond Yields Lower Than Short-Term Bonds? Why Would Anyone Buy Long-Term Bonds?
Disclosures:
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.
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.