Sunday, December 1, 2024

S&P 500 index funds have had a decade from hell

It’s investment advice you’ve probably heard over and over again: Buy an index fund, don’t touch it, and watch your nest egg grow.

And for good reason. History has proven that this is a great strategy if investors want to hold for the long term. For example, $100 invested in the S&P 500 In 1990 it would be worth $3,220 today. Index funds that track major indexes have such good returns, while requiring so little effort, that investing legend Warren Buffett tells most people to put their money into them.

This approach will continue to succeed over decades. This is even more so for investors who buy on dollar price-averaging or long-term increases during market fluctuations.

But the evidence shows that this is a terrible time to buy into the broader market, especially for investors looking to hold for a decade.

That’s a bold statement, considering the S&P 500 is up 25% over the past year.

But that’s it. The market is so frothy in terms of valuation that it’s setting itself up for poor returns over the next 10 or so years. At least that’s what the numbers say.

Valuations measure how expensive stocks are relative to history. One of the most common metrics is the 12-month forward price-earnings ratio, which compares the price of a stock or the overall market to near-term earnings expectations. There is the price-to-earnings-growth ratio (PEG), which considers long-term growth prospects.

But for determining long-term returns, other metrics prove more reliable when it comes to determining how stocks will perform over the long term.

See also  'Hotel Rwanda' hero freed from Rwanda prison

Take the Shiller cyclically-adjusted price-to-earnings ratio (CAPE), which is the 10-year average of the 12-month trailing PE ratio. It normalizes the scale by smoothing the outlier data.

According to an analysis Michael FinkeProfessor of Wealth Management at The American College of Financial Services, the CAPE ratio has a remarkable ability to predict future earnings. In 2020, Finke conducted a regression analysis, a statistical test that identifies the effect that certain variables have on a given outcome, and between 1995 and 2010, CAPE ratio levels at any given time explained 90% of the S&P 500. Return in the next decade.


The CAPE ratio is the S&P 500

Michael Finke/Consultant Perspectives



The relationship between CAPE ratio and future returns is negative for 10 years. The S&P 500’s current CAPE ratio is 35.7, trailing only the 1999 and 2021 levels and sitting above the highs reached in the 1929 bubble. A level of 35.7 estimates annual returns of about 3% over the next decade.


Shiller Pe Ratio S&P 500

Curufocus



While that’s not all that bad, the benchmark index has returned 10.9% annualized since 2008. Also, 10-year Treasury notes offer a risk-free annual return of 3.89%.

When Finke issued his statement, John RegenthalerMorningstar’s vice president of research was surprised by the findings.

“Have you ever seen such a tight match between a stock market signal and future performance? If so, let me know, because I can’t think of an example like it,” Regenthaler wrote in July 2020. “I believed Finge’s work was accurate, given his background and the reputation of the website that published the article, but I admit I wasn’t entirely convinced until I ran the numbers myself.”

Enter John Husman. Hussman, chairman of the Hussman Investment Trust, is a so-called perma-bear. While it’s easy to ignore these categories, his data is hard to argue with.

Hussman’s preferred valuation measure is the total market capitalization of nonfinancial stocks—the total value added of those stocks—basically a price-to-earnings ratio. The real economy Companies.

Like the CAPE ratio, it has an uncanny ability to predict where the market will go in the long run. The more aggressive the initial assessment, the better its predictive power over the next 12 years.


Market cap of total value added non-financial stocks

Hasman Funds



As the arrow in the chart above shows, readings as of mid-July show a projected annualized S&P 500 return of -6% over the next 12 years.

Here’s the gauge that recently hit an all-time high.


Market cap of total value added non-financial stocks

Hasman Funds



Hussman often writes that high initial valuation levels lead to “long and interesting journeys to nowhere” that will roll out in market economic cycles over the next 12 years. For example, the S&P 500 was even lower in early 2012 than it was in early 2000 at the height of the dot-com bubble. Meanwhile, investment in the post-bubble lows of 2002 will be more than 50% by early 2012.

To reiterate, these metrics provide an outlook for the overall S&P 500 over a specific time frame of 10 or 12 years. Ratings don’t matter that much in the short term. A 2021 Bank of America chart shows the impact initial valuations have on subsequent returns over the following 12 years.


Bar graph showing the value of the predictive power of normalized returns on subsequent holding period returns since 1987.

Bank of America



Case-in-point, the levels of the two valuation metrics above were historically high a few years ago, yet the S&P 500 is up 47% since the start of 2021.

Similarly, if you’re in your 20s or 30s and don’t plan to touch your stock market assets for decades, the data shows this may not be so relevant.

But given the numbers over decades, there’s little doubt that initial valuations will affect future returns in the long run. If you plan to take your money out of the market in about 10 years, now may not be the best time to buy.

Related Posts