My Comments: I don’t think of myself as a woe and gloom person. I really want stocks and bonds to perform well and make money for my clients. That’s the ideal outcome for them and for me.
But as you’ve heard me say before, we do not live in a perfect world. And right now it’s far from perfect in terms of the markets and the opportunities for our investment portfolios to grow.
I wish I had a perfect answer, but I don’t.
by Shawn Tully | December 1, 2016
For a few golden weeks in November, U.S. stock markets loved Donald Trump. As this magazine went to press in late November, equities were in the middle of a record-setting rally that charged Wall Street pundits and strategists with a fresh sense of optimism. Market watchers at Goldman Sachs GS 2.54% , JPMorgan Chase JPM 1.98% , and Raymond James RJF 2.34% cited Trump’s pledge to roll back burdensome regulations and lower corporate tax rates as decidedly bullish for U.S. stocks.
But for investors who study the forces that govern stock prices long term, the outlook was no more upbeat after the election than it was before—and it was far from terrific. Put simply, equities are really, really expensive, and only became more so after Trump’s surprise victory. “The best predictor of future returns is whether you buy at low or high prices relative to earnings,” says Chris Brightman, chief investment officer of Research Affiliates, a firm that oversees strategies for $161 billion in mutual funds and ETFs. “Today individual investors and fund managers who expect the near-double-digit returns we’ve seen over history will be sorely disappointed.”
James Montier, a value investor at asset-management firm GMO, provided this dim appraisal of U.S. stocks: “This is a hideously expensive market, and I don’t need to own it.”
Take a deeper dive into the thinking of pessimists like these, and it’s hard not to reach similar conclusions. (More on that in a moment.) Fortunately, investors can garner much bigger rewards by looking beyond the super-rich American market and beyond stocks in general. This is the time to take a broad, venturesome view encompassing all the best—meaning mainly the cheapest—places to put your money.
As we’ll see, spreading your portfolio across a broad range of underpriced assets can add crucial percentage points to your returns. Best of all: If you do it thoughtfully, you can improve your odds while shouldering little or no extra risk.
Chris Brightman, chief investment officer of Research Affiliates, thinks that a foreign-centric stock portfolio could outperform a U.S.-only portfolio by as much as three percentage points a year over the next decade.
Rising inflation could be a mixed blessing for stocks. But it’s good for investors in floating-rate bank loans (whose interest payments rise with inflation) and TIPS, Treasury securities whose principal rises with consumer prices.
Collect a Check
When stock price growth is sluggish, dividends account for a much bigger share of investors’ gains. The problem: Dividend-paying stocks are historically expensive right now.
Let’s examine why the near future for U.S. stocks looks downbeat. Over the past 100 years, the S&P 500 has delivered average annual returns of 9.6%. Wall Street optimists and many pension fund managers believe that past is prologue and that equities will continue to deliver those historical returns. But it won’t happen for a while for one reason: On average the folks who pocketed those nearly double-digit gains in past decades were buying at far lower prices than the big valuations prevailing today.
Here’s why the market math is so daunting. When you purchase a broad swath of equities, say an S&P 500 index fund, the returns you can expect over the next decade or so comprise four building blocks: the starting dividend yield, projected growth in real earnings per share, expected inflation, and the expected change in “valuation”—that is, the expansion or contraction in the price/earnings (P/E) multiple.
Let’s start with the first building block: the dividend yield. The main reason high prices foretell paltry gains is that rich valuations make dividend yields smaller. It’s dividends that have provided the richest rewards to investors. Since 1871, the S&P dividend yield has averaged 4.9%, though it has been lower in recent decades.
The problem is today’s highly elevated P/E ratio. The P/E of the S&P 500 stands at 24; that’s well above the average of 16 over the past century, and 19 since around 1990. Big U.S. companies, on average, pay out half their earnings in dividends. But because the “P” is so towering, you get far fewer dollars in dividends for every dollar you pay for stocks. Today the S&P dividend yield stands at a slim 2%.
So how much will the second building block—real growth in earnings per share—add to that weak yield? In today’s bluebird forecasts for stocks, the biggest fallacy is highly inflated expectations for earnings. “Since the mid-1980s, profits have grown at unusually high rates, giving rise to the mistaken idea that we were in a ‘new normal,’ ” says Brightman. “Earnings rose to a historically high share of national income that they couldn’t possibly sustain.” In fact, the inevitable decline has already begun. S&P profits, based on trailing earnings per share over the past four quarters, peaked in September 2014 and have dropped by 15% over the past two years.
Although earnings careen in a zigzag pattern from year to year, their trend stretching over long periods is remarkably consistent. U.S. profits expand with the overall economy, growing at an annual clip that has exceeded 3% over the past century. But what matters to investors is earnings per share, what they’re effectively receiving in dividends, buybacks, and reinvested profits that drive capital gains. And it turns out EPS expands at just half that rate, or around 1.5%, adjusted for inflation.
The reason for the big lag is twofold. First, companies constantly issue new stock to reward executives and make acquisitions, and the new issues far exceed buybacks. Those extra shares dilute the portion of profits flowing to existing shareholders. Second, new enterprises, often funded by IPOs, invade their markets and reduce the incumbents’ share of the industry’s profit pie. “Profits can grow above trend for certain periods, but they’re still elevated,” says Brightman. “The best assumption is that they grow at the historical real rate of 1.5%.”
To sum up so far: A 2% dividend yield, plus the 1.5% projected EPS growth, should deliver a future real return of 3.5% a year for the next decade. Add the third building block, the approximately 2% inflation predicted by the Fed, and the total expected return on big-cap U.S. equities comes to just 5.5%.