Investors will need to diversify across other asset classes and take an active approach to equity investing.
The S&P 500, a key benchmark for the stock market, has delivered impressive returns: over 12% annually for the past decade, 14% over the past five years, and almost 21% year-to-date. Its performance has surpassed most other asset classes, even after adjusting for risk. No statement from Wall Street has ever been more true than “past performance is no guarantee of future results” so we need to consider how this great past performance might inform us about future returns.
It’s useful to first separate the sources of these returns into categories: Earnings per Share (EPS), Price-to-Earnings (P/E) Ratio, and Dividend yield.
- Earnings per Share (EPS): This represents the profit a company earns per share of outstanding stock.
- Price-to-Earnings (P/E) Ratio: This figure shows how much investors are willing to pay for a dollar of earnings. For example, if a stock has earnings of $1.00 and it is trading at a price of $15.00, then it is said to have a price-to-earnings ratio of 15.
- Dividends: These are cash payments of a portion of a company’s profits to shareholders.
It is the cumulative change in these components that determines an investor’s return.
An increase (decrease) in any one of these three components could contribute to an increase (decrease) in total return. The issue for the S&P 500 at present is that a significant increase in any one of these areas seems unlikely.
Estimating Future Returns
Using these components, we can estimate the S&P 500’s future total return. Here’s a breakdown:
- Dividend Yield:
The S&P 500’s current dividend yield is 1.32%.
Historically, this has averaged around 1.83%. For our forecasting, we can take the middle ground and use a dividend yield of 1.57%.
- Earnings Contribution:
For the S&P 500, current earnings represent around 12% of sales. Historically speaking, this is high, but it’s not entirely unreasonable to expect it could stay steady.
- Price-to-Earnings Ratio Return:
Here, we have a more speculative source of return. No one can know for sure how willing an investor will be to pay for earnings out into the future. The S&P 500’s current price-to-earnings multiple is about 21x on a going forward basis. Historically, this figure has been lower. However, given recent declines in long-term interest rates, we can make an argument that it might stay around this level.
So far, changes in the three components have only amounted to 1.57% in annual total return, based on the dividend yield. However, if we assume the earnings percentage and the price multiple stay the same, there is still one thing that can increase the dollar amount of those earnings:
- Sales Growth Contribution:
Given that the earnings contribution is taken from revenue, growth in sales could push earnings higher. Sales growth for the S&P 500 has averaged around 5% for the last 10 years. If we assume that will continue, earnings growth would be the largest contribution to total return over the next decade.
Combining these elements, we estimate the total annual return for the S&P 500 over the next 10 years to be around 6.6% with almost all the estimated gains coming from earnings growth driven by increased sales.
Key Considerations
While this projection might seem modest compared to recent past performance, it’s important to keep a few things in mind:
- Potential for Outperformance:
Projections are inherently uncertain. Historical data shows that similar forecasts have often been too conservative. The market has a history of surpassing such predictions, and there’s always potential for unexpected growth, particularly from innovative sectors like technology and burgeoning trends such as A.I.
- Growth Opportunities:
Within the S&P 500 there are innovative companies that can be expected to produce returns beyond the overall index’s average. The broad index may have a modest outlook, but unique companies within it could offer substantial returns.
- Diversification and Strategy:
Many of the companies in the S&P 500 remain core components of our portfolios. However, we believe that relying solely on one approach – one index – will not prove optimal over the long run. Diversification across different asset classes and strategies — factors such as momentum, value, and growth — is the foundation of a well-rounded investment strategy and is crucial to achieving acceptable risk adjusted returns.
Conclusion
Understanding stock market returns requires that we consider the components of that performance, namely: earnings, valuation, and dividends. Our forecast of a 6.6% annual return for the next 10 years incorporates these elements and assumes a return achieved primarily by steady sales growth and a consistent dividend payout.
The potential for below average returns from “the market” underlines the importance of an active approach to investing. To achieve their financial goals, investors will likely need to identify alternate asset classes and areas of the market that offer greater potential.
Rhett co-founded Black Arrow Capital, LLC in 2023. He serves as Head of Portfolio Management and directs the company’s operations, service, and compliance activities.
This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products or investments in general. None of the information herein constitutes an investment recommendation, investment advice or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors. All investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable. Black Arrow Capital, LLC and affiliated persons are not responsible for errors, inaccuracies, or omissions of information.
