A monster 10 years for US stocks has showered money on the buy-and-hold faithful and made virtually every other asset class an also-ran.
So great have the gains been that some fairly simple math shows that however roaring the 2020s turn out to be, reprising the last decade’s bounty will take near-miracle expansions in earnings and valuations.
The math comes courtesy of Jordan Brooks, a principal at AQR Capital Management. He analyzed drivers in the market that account for gains of almost 12% a year since 2013 versus inflation-adjusted rates on cash. And given stocks’ elevated starting point now, he concluded, generating even average returns is something of a long shot.
“Stars must align in order to see an encore of last decade’s equity market performance,” Brooks said. “After long periods of outperformance, valuations are typically rich, which results in weaker forward-looking expected returns.”
Leave it to the quants to find the dark lining in markets that have acted like cash registers since the trauma of the global financial crisis. This year was no exception, with the S&P 500 jumping 24% and the tech-heavy Nasdaq 100 surging nearly 54%, its best annual gain since the dot-com boom of the late 1990s. While nothing in the numbers prohibits stocks from continuing to rise, the math reveals the scope of the challenges to a repeat with valuations as stretched as they are now.
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Brooks’s analysis focuses on the 10 years through this June, but its upshot holds for a market that has added another 7% since then. He calculated the return on the S&P 500, after subtracting Treasury bill yields, at 11.9% per year for that decade, pummeling everything from non-US developed-market equities to commodities to complex quant strategies.
In 2023, the index’s runup defied both sceptical Wall Street prognosticators and large numbers of investors who were positioned defensively. The end of the Federal Reserve’s historic rate-hiking cycle fueled optimism a recession will be avoided, sparking rallies in everything from speculative tech shares to junk bonds.
The issue for stock bulls is valuation after a decade-long expansion, as Brooks sees it. Going by its cyclically adjusted price-earnings ratio, which smooths out variations in earnings by using a 10-year average of trailing income, the S&P 500 is priced above 30 times profits, among the higher readings on record.
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By definition, one of three things has to happen for equities to appreciate: earnings must grow, valuations expand or dividends climb. Brooks’s point is simple: replicating the gains of the last 10 years requires massive increases in the first two components. Even if real earnings go up by a relatively generous 4.5% annually over the next decade, a repeat performance for the S&P 500 would take the cyclical P/E to a heretofore unheard of 55, he calculates.
Michael O’Rourke, chief market strategist at JonesTrading, notes there’s an additional complicating factor: The days of near-zero benchmark interest rates are over.
“There was significant multiple expansion with massive monetary policy stimulus. I don’t expect the past decade to be replicated,” O’Rourke said. “The economy is in the midst of a structural shift that should prove less beneficent.”
To be sure, Corporate America’s profit machine has managed to generate earnings well above expectations again and again. So it’d hardly be shocking if that continued. But even at a historically high rate of expansion, the pressure on valuations would be daunting. Should real earnings rise annually at 6% — the 90th percentile of gains over the last 70 years — cyclical P/Es would need to get to 50 for returns to match the last decade, going by Brooks’ math. This would put them above the peak hit during the dot-com bubble.
“In even the most extreme real earnings scenarios, stock market valuations would need to pop to all-time highs,” he wrote.
For now, with euphoria building over artificial intelligence and the end of Fed tightening, analysts see earnings skyrocketing. The consensus forecast for profit growth is 11% in 2024 and 12% in 2025, data compiled by Bloomberg Intelligence show. But gains like that are rare. Earnings last posted double-digit gains in back-to-back years in 2017 and 2018.
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“The market is priced for perfection, given its very high valuation,” said Matt Maley, chief market strategist at Miller Tabak + Co. “The market is not going to be able to depend on multiple expansion this year. It’s going to have to see the kind of growth that helps the ‘E’ part of the ‘P/E’ ratio rise in a meaningful way.”
This year was a reminder for many that too much caution can be costly.
Skeptical investors missed out on the rally as cash funds attracted US$1.3 trillion ($1.72 trillion) of inflows, dwarfing the more than US$150 billion that flowed into global stocks, according to Bank of America Corp. citing EPFR Global data. The seven biggest stocks soared over 100% this year. One of them, Nvidia Corp. — maker of the chips needed for AI — more than tripled in price.
For Brooks, the next stage is more difficult. AI fever has to either translate into historic real earnings growth or embolden investors to pay more for earnings than they’ve ever done before.
“One could be very optimistic about the ability of artificial intelligence to improve corporate profitability,” he said, “but still say it’s highly unlikely that equities will post a repeat performance of the previous decade.”
