It has been a great decade for investors. According to Goldman Sachs’ calculations, the S&P 500 stock market index has returned 13 percent annually for the last 10 years, higher than the long-term average of 11 percent. However, the team at Goldman does not expect the good times to keep rolling; they recently forecasted an annualized nominal return (i.e., not including dividends) of just three percent for the next 10 years.
Goldman cited higher stock valuations, economic fundamentals, interest rates, corporate profits, and concentration of mega-capitalization companies in the index as reasons to expect such lackluster returns. JP Morgan predicted a similarly pessimistic outlook last month, forecasting six percent per year over the next 10 years.
Perhaps surprisingly, I am OK playing if that is the hand I am dealt. The owner of a merger and acquisition firm in the money-management industry posed the following question on LinkedIn:
Goldman Sachs recently came out with a prediction that the S&P 500 will average 3 percent over the next decade. Do you think that is actually going to be true? What are your thoughts on the index that will perform the best over the next 10 years?
I responded:
It’s plausible. That’s 4-6 percent earnings growth combined with multiple compression. I can work with that. The index would increase nominally by about one-third over the decade; a portfolio tied to the index would increase by about two-thirds if you reinvest dividends.
Those three-percent annual returns would not occur linearly. Somewhere along the way, the index crashes 20-30 percent a couple of times, so I would have the opportunity to buy stocks more cheaply within that decade, even if the average return over that time is weak.
I’ve seen worse.
Let’s focus on the “I’ve seen worse” comment. I was not trying to be cavalier.
I started investing around 1989, after having been educated by my father since the late 1970s. It was before my time, but the 10-year stretch from 1964 to 1974 experienced annual returns of just 1.3 percent as it digested an oil shock. The average annual returns of the S&P 500 for the 10 years through 1978 were not much better at 3.2 percent due to inflation so high it would make recent numbers blush.
I started working in the financial industry as an intern at Smith Barney (don’t bother looking it up; it doesn’t exist anymore!), probably around 1994. I started Berkshire Money Management in 2001 amid the technology bubble’s popping.
The period from 1999 to 2009 is called the “Lost Decade.” The S&P 500 had an average annual return of around -0.9 percent. So, yeah, I have seen worse. If I calculated correctly, the worst 10-year stretch for the S&P 500 was from 1929 to 1939, when the index lost -5.3 percent annually as it struggled through the Great Depression.
But are such lousy returns of merely three percent per year for the next decade more than plausible? Are they likely?
I hate to paint too rosy a picture of the stock market; I don’t want new readers to perceive me as a Pollyanna. Many will recall that my investing philosophy often ranges from “conservative” to “running scared.” Sure, I have been invested heavily over the decades, including the last two years, when I have been primarily in domestic, large-cap stocks. I am aware of the tendency of the broader stock market to deliver positive returns over the long term, but that does not mean I am oblivious to warning signs. So, let’s dissect Goldman’s forecast not to argue that stocks will go up but, instead, to throw shade on their math and history.
Firstly, history shows that when the markets return only three percent per year over 10 years, those periods are associated with significant problems, like an oil shock, the Great Depression, a financial crisis, the technology bubble popping, or high and persistent inflation. Historically, there needs to be a crisis for such low returns, not just headwinds.
Secondly, valuations are not the boogeyman Goldman might suggest. Keep in mind that valuations are affected by corporate profitability.
The 12-month-forward price-to-earnings (P/E) ratio of the S&P 500 is about 21.7. That compares to the 10-year average of 18.1. Goldman has a point here—that is an expensive market. Aggregate corporate earnings for the S&P 500 companies are expected to be about $267 per share over the next 12 months. Earnings per S&P 500 share would have to increase to $321, or 20 percent, for P/Es to level off at the 10-year average. That is a big, big lift. Wall Street analysts are projecting earnings growth of 15.2 percent in the calendar year 2025, so that is close. However, Wall Street analysts are often overly optimistic, so perhaps we should expect a bit less.
Earnings growth for calendar year 2024 should be close to nine percent, which seems more realistic than 15.2 percent for the following year. Could earnings growth top 15.2 percent? If companies embrace artificial-intelligence tools, then yes. However, the adoption rate of the latest technologies is often slow, so that double-digit earnings growth might be a conversation for the second half of this decade.
Still, while expensive, the market’s valuation is not crisis level, like before the Lost Decade following 1999. The P/E ratio of the S&P 500 index in 1999 was close to doubling today’s P/E. The P/E ratio of the Nasdaq 100 was near triple digits (not a typo) in 1999; today, it is about one-third that level.
Thirdly, it is OK for the S&P 500 to have a handful of companies representing a large percentage of the index.
The greater a company’s market capitalization, the more its price movement affects the S&P 500. Those mega-cap companies are global, best of class, fast growing, and likely to maintain dominance. If they falter relative to their competition, then whichever companies knock them out of their perch will eventually be put into the S&P 500 index (if they are not there already). As the competitor rises in prominence, so will its market capitalization, which will influence the index level more. Simultaneously, the company that got knocked down a peg will see its market cap shrink and have relatively less influence on the index. As long as entrepreneurs continue to innovate, it almost doesn’t matter which companies in the index take the lead.
Will the S&P 500 only return an average of three percent for the next decade? Possibly. Is Goldman’s rationale flawed? I think so.
Let the stock market gods give me those three percent returns. Somewhere in the middle of that stretch would probably be a giant sell-off and a tremendous rebound. I will be up to the challenge of trying to figure out when to get out and when to get back in.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
