Hope is not a strategy.
That’s important to remember, since many of us—most likely, unconsciously—are extrapolating the past decade’s stellar stock market returns into the future. It’s very unlikely we’ll be that lucky: Over the last decade the stock market has beaten cash by 11.9% annualized—one of the best 10-year returns in U.S. history.
Believing in a repeat performance represents a triumph of hope over experience.
Of course, it’s not impossible that the stock market’s return over the next decade will be as good as the last decade’s. But possibility is different than probability. And you should be basing your retirement financial plans on realistic assumptions, since the equity market’s long-term return is perhaps the single most important determinant of your retirement standard of living.
I am not the first to argue that the next decade is unlikely to be as good as the last, since the current stock market is overvalued according to almost every valuation indicator. But a new analysis reaches a similar conclusion from a different angle: It takes a bottom-up approach to estimating the stock market’s likely next-decade return, decomposing the market’s excess-of-cash return into four distinct components. It increases our confidence in a forecast when two distinct analytic approaches reach a similar conclusion.
It’s titled “Driving with the Rear-View Mirror: Will we see a repeat of the past decade of U.S. equity returns?”, and the analysis was conducted by Jordan Brooks, a principal at AQR Capital Management. The four components into which Brooks breaks down the stock market’s excess-of-cash return are listed below, along with the contribution each made over the last decade:
How much will each of these four components contribute to the stock market’s return over the next decade? Here are Jordan’s estimates:
- Real cash return: 0.5%. Jordan bases this on the median real interest rate projection made by members of the Federal Reserve’s Open Market Committee. Note that you have to subtract this from the contributions of the other three components to get the excess-of-cash return. Since the last decade’s real cash return was minus 1.7% annualized, a plus 0.5% return over the next decade annualized means the stock market’s nominal return would have to be 2.2 annualized percentage points better in order for equities simply to do as well on an excess-of-cash basis.
- Dividend yield: 1.5%. Not much room for discussion here.
- Real earnings growth rate: 2.9%. Jordan bases this estimate on a simple statistical model that forecasts future real earnings growth based on trailing real earnings growth and real GDP growth. This model has been surprisingly accurate: Since 1950, its forecasts have been highly correlated with actual growth rates—and when the model has been wrong, it more often than not has been too optimistic rather than too pessimistic. The model currently is forecasting a real earnings growth rate over the next decade of 2.9% annualized.
These three of the four return components translate into a forecasted excess-of-cash return over the next decade of 3.4% annualized. Furthermore, these three components are relatively predictable, and when wrong, are wrong by only a percentage point or two at the most. As a result, most of the heavy lifting will have to be done by expanded earnings multiples if the stock market over the next decade is to come anywhere close to the last decade’s 11.9% annualized.
That’s asking a lot, since the stock market’s earnings multiples are already stretched. As I pointed out late last month, the stock market’s CAPE ratio is already at the 91st percentile of the distribution of monthly readings since 1950. Jordan calculates that it nevertheless would have to nearly double from current levels—to 60, from its current level around 31—if, given the projections of the other three components, the stock market is to produce an excess-of-cash return over the next decade of 11.9% annualized.
That would be far higher than the CAPE’s previous record high of 44.2, set at the top of the Internet bubble.
The implication of Jordan’s analysis is sobering: Do you really want to base your retirement planning on the hope that CAPE ratio will become so high that it makes the market’s valuation at the top of the Internet bubble seem sensible in comparison?
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].
Read the full article here