Sizing the Downside

Following two stellar years for the stock market, many market strategists are speculating that future stock market returns will be much lower. I can’t say I disagree. One of the best predictors of future stock market returns is market’s valuation level at the beginning of the measurement period. The S&P 500 is currently trading at a price-to-earnings (P/E) multiple of 22x expected earnings over the next year compared to the 10-year average of just 18.4x. That high P/E multiple would seem even higher if we consider the fact that downward trend in interest rates has now reversed, with the yield on the 10-year Treasury currently sitting at 4.41% compared to the 10-year average of just 2.45%. All else equal, P/E multiples should be lower when interest rates are higher (and vice versa) to reflect the opportunity cost of not owning bonds and the higher cost of borrowing for corporations (which can negatively impact earnings).      

So given the high level of current stock valuations, I wanted to do a quick-and-dirty sensitivity analysis on future expected stock market returns. The two variables we will use to predict returns over the next 10 years will be the 1) the pace of earnings growth over the next 10 years, and 2) the ending price-to-earnings ratio. We also assume that the S&P 500’s dividend yield of 1.3% remains unchanged over the next 10 years. 

The table shows that even if the S&P 500 P/E ratio falls closer to the 10-year average of around 18x, the S&P 500 would still produce a total annual return of between 4.2% and 9.1%, depending on the pace of earnings growth over the next 10 years. Importantly, the midpoint of that range, roughly 6.7%, is still well above the current yield on the 10-year Treasury bond of 4.4%. Now, is it possible that earnings growth could come in well below the historical average of around 6%-7%?  Of course. But the table shows that even if earnings growth falls to 5% annually (which is only slightly above the expected growth in nominal GDP) and the P/E multiple contracts by nearly a third to just 15x, the S&P 500 would still produce a positive return of 2.4% annually – hardly a doomsday scenario. On the other end of the spectrum, earnings growth of 10% annually while keeping the P/E ratio flat at 22x would produce an annualized total return of 11.3%, resulting in nearly a tripling of one’s investment over the 10-year time frame. 

It’s easy to get pessimistic when listening to the talking heads on TV. And it is true that the last couple of years have produced spectacular returns, leaving valuations on the high side. But good investors are able to step back, ignore the rhetoric and remain focused on the long term. There is simply no way to time the stock market with any degree of precision or consistency. A decision to exit stocks today means one would also have the ability to predict a better time to get back in later. Don’t fall for it.