The Most Powerful Indicator of Long-Term Market Returns
Since 1970 this indicator "explains" 71.5% of returns from the S&P 500
In Tuesday’s update I took a quick look at the short-to-intermediate term outlook for stocks.
In this issue, I’ll back up for just a moment and take the long-term “30,000 foot” view starting with this chart:
Source: Bloomberg
This is a simple scatterplot of two variables: The price-to-earnings ratio for the S&P 500 based on 10-year average earnings (horizontal x-axis) versus the subsequent annualized returns for the S&P 500 including dividends (vertical y-axis)
For example, at the end of January 1970, the S&P 500 was trading at 18.62 times its 10-year average trailing earnings and went on to produce annualized gains of 7.33% from the end of January 1970 through the end of January 1980. That would represent one blue dot on this chart.
The chart includes a total of 515 monthly rolling 10-year return periods starting with January 1970 through January 1980 and ending with November 2012 through November 2022.
As you can see, there’s a strong negative correlation– when the market is expensive (further to the right on my chart), historically the stock market produces below-average returns in the subsequent 10-year holding period. I’ve overlaid a simple linear equation and trendline to model this relationship.
The R-squared number included with my chart suggests stock market valuations on this basis explain 71.5% of subsequent 10-year returns from the stock market.
That’s a powerful indicator.
The average rolling 10-year annualized gain including dividends over this period is 11.29%.
About a year ago, at the end of 2021, the S&P 500 traded at 37.53 times earnings on this basis suggesting average annualized returns from stocks over the decade from year-end 2021 through year-end 2031 of just 3.33% annualized, about 8 percentage points below the long-term average.
At the end of November last year, the S&P 500 traded down to 30.83 times earnings on this basis as the 13.1% decline in the S&P 500 through the first 11 months of 2022 brought down valuations by almost 7 turns. However, plugging the end November valuation into this simple, linear equation still yields a 10-year annualized return of less than 6.8%, some 4.5 percentage points below the long-term average.
(Note: I have yet to update my spreadsheet to reflect the final month of 2022 but will do so by early next week.)
If you think that doesn’t sound like a huge difference, just remember the magic of compounded returns:
An 11.29% annualized return over 10 years represents a 191.5% total gain compared to just a 93.1% gain over a decade at 6.8% annualized.
There are a few caveats worth noting here.
First, while market valuations are a powerful long-term indicator of returns from the stock market, they’re a terrible short-term indicator.
For example, here’s the same scatterplot I just showed you except I’ve plotted the 10-Year average P/E measure of stock market valuations against subsequent 2-year stock market returns:
Source: Bloomberg
To be fair, there’s still a negative correlation here – high market valuations tend to signal below-average two-year returns from the stock market. However, the relationship is far weaker and the R-squared drops from 71.5% for 10-year annualized returns to just 10.5% for 2-year annualized returns.
So, just because the stock market is still expensive today doesn’t tell us much about returns in 2023 or 2024; however, it does suggest strong probability of below-average returns into the early 2030s.
My short-term market target for 2023 remains a dip to the 3,000 to 3,100 level on the S&P 500, which would imply a valuation of 22.6 to 23.4 times based on 10-year average earnings for the S&P 500 through November 2022. Plug that into the same equation in my chart above and you get an average annualized gain of 10.5% to 11% over the next decade, close to in-line with the long-term average.
At 2,400 on the S&P 500 – a 50% decline from the January 2021 peak – the S&P 500 would be trading at 18 times 10-year average earnings, which would suggest long-term average annualized gains north of 13%, comfortably above the long-term average.
Put in a different way, based on monthly returns since January 1970, if you bought the stock market at a valuation of 30.8 or above (roughly the current level), your subsequent 10-year returns were negative 37.5% of the time and below 5% annualized 73.4% of the time.
In contrast, with a valuation under 23.5 times (roughly my S&P 3,100 target), your subsequent 10-year returns were positive 100% of the time and above 8% annualized almost 90% of the time.
Finally, with a valuation under 18 times at the end of a month, the S&P 500 produced subsequent 10-year returns north of 8% in 187 of 188 periods and north of 10% annualized in 181 of 188 cases (96.8% of the time).
Bottom line: The market is still expensive right now; however, a dip to 3,000 to 3,100 would represent a solid, low-risk buying opportunity for long-term investors. And, if there’s a sell-off to around 2,400 to 2,500 on the S&P 500 it would represent one of the best buying opportunities for the broader market since at least 2009.
Two More Important Caveats
At this point, some of you may also be thinking that while 6.8% annualized returns from the stock market over the next decade might be below average, it doesn’t sound terrible.
That’s particularly true after the stock market drubbing we saw last year, and in light of the still-paltry yields currently available from the bond market.
However, consider the charts I just outlined are based on nominal values, NOT adjusted for inflation. Thus, if you bought the S&P 500 at the end of January 1970, for example, your returns from holding stocks through the end of January 1980 was 7.33% annualized, below average but still comfortably positive and almost 103% in total return from capital gains and dividends over the decade.
However, the annual rate of inflation over the same period was 7.48%, so your real return from the stock market after inflation was negative.
And, the S&P 500 was much cheaper in January 1970 (18.6 times earnings) compared to right now.
There’s a notable negative correlation between stock market valuations and the current annual rate of inflation:
Source: Bloomberg
This chart is based on the S&P 500’s P/E since December 1959 (based on trailing 12-month earnings) compared to the year-over-year change in the CPI Index. As you can see, the further to the right you move on this chart (higher inflation) the lower the P/E ratio for the S&P 500.
The R-squared here is about 34%, so it’s hardly a perfect relationship.
However, I’d also note that at inflation rates above 7% or so (the current year-over-year rate is 7.1%), the relationship between inflation and P/E tends to be tighter.
This makes some logical sense – after all, periods of high inflation, like the 1970s, tend to correspond to periods of economic volatility and instability. In such environments, investors have historically demanded cheaper valuations to justify holding stocks.
My current view is inflation will come down further in 2023; however, inflation is likely to remain higher, and more persistent, over the next 10 years than the low-inflation norm of the past two decades. Thus, even if the stock market does produce positive annual returns over the next decade from current levels, those returns may not be positive on a real (inflation-adjusted) basis.
That’s a good reason to demand lower valuations for the S&P 500 before increasing exposure to stocks.
The most likely alternate scenario in my view is that inflation does come down quickly in 2023 and stays in-line with or below the Fed’s target; however, the cost of that in the short term would most likely be a much deeper recession than the market currently expects and consequently a move well under 3,000 for the S&P 500 next year.
Thanks for reading The Free Market Speculator. In my next issue I plan to take a closer look at relative market valuations and two of the ways you can outperform the S&P 500 even if long-term returns — returns from buying and holding the S&P 500 — are sub-par over the next decade.
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DISCLAIMER: This article is not investment advice and represents the opinions of its author, Elliott Gue. The Free Market Speculator is NOT a securities broker/dealer or an investment advisor. You are responsible for your own investment decisions. All information contained in our newsletters and posts should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.